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Long-term themes review March 7th 2018

FullerTreacyMoney has a very varied group of people as subscribers. Some of you like to receive our views in written form, while others prefer the first-person experience of listening to the audio or watching daily videos.

The Big Picture Long-Term video, posted every Friday, is aimed squarely at anyone who does not have the time to read the daily commentary but wishes to gain some perspective on what we think the long-term outlook holds. However, I think it is also important to have a clear written record for where we lie in terms of the long-term themes we have identified, particularly as short-term market machinations influence perceptions.

Email of the day on the differences between China's authoritarianism and India's chaotic democracy:

I have just returned from a visit to India and I visited China last autumn. I was struck by the difference between the two societies. In China I found an almost total absence of religious belief while in India I discovered an almost nationwide attachment to different religions and traditional mysticism. While I saw "tomorrow" all over China in the form of futuristic cities like Shanghai and Hong Kong, I only saw "yesterday 's poverty and superstition" in India. David and you harp on the importance of governance. I heard many Chinese persons state that as long as their material well-being improves, they are prepared to accept the absence of democracy because this enables the government to take action without vested interests standing in its way. In India democratic discussion was said by the persons I met to be an obstacle to rapid and firm decision-taking. What is your opinion on this?

Thank you for sharing your impressions from China and India following your travels. You are not the first subscriber to have asked this question. There have been a number of people over the years who, having visited China and India, said that on coming home they sold their India positions and transferred the balance to China.

China was making headlines today because Xi Jinping’s bid to remain in power following the end of his official term was rubber stamped by the People’s Congress today. It has been a key object of Xi’s to do everything possible to ensure China sits on a level playing field with the USA on the international stage. Modernisation of the military, greater surveillance of the domestic population, strengthening the nation’s censorship of the internet, the Belt and Road infrastructure program, dominating international engagement with African countries, spending on research and development and infiltration of university campuses in the OECD are all part of that plan.

China Turns Fiscal Screws While Targeting GDP Growth Around 6.5%

This article from Bloomberg News may be of interest to subscribers. Here is a section:

Xi has ratcheted up his drive to curb debt risk, pollution and poverty at a time when the world’s second-largest economy is on a long-term growth slowdown. His efforts to rein in spending contrast with an historic expansion of U.S. borrowing under Donald Trump during a period of economic expansion.

The 2018 targets “suggest slower growth and a fiscal drag,” said Callum Henderson, a managing director for Asia-Pacific at Eurasia Group in Singapore. “This makes sense for China in the context of the new focus on financial de-risking, poverty alleviation and environmental clean-up, but is less good news at the margin for those economies that have high export exposure to China.”

Growth handily surpassed 2017’s target with a 6.9 percent expansion that was the first acceleration since 2010. Economists forecast a moderation to 6.5 percent this year amid the ongoing deleveraging drive and trade tensions with the Trump administration and a further deceleration to 6.2 percent in 2019.

China has significant challenges ahead as it engages with deleveraging, particularly among the regional lenders. However, it is also worth considering that fiscal discipline at this stage in the cycle is admirable since it will leave the government with some firepower when the economy next slows. That is the exact opposite of what the US government is doing at present which is of course why interest rates are set to continue to rise.

What Does Population Aging Mean for Growth and Investments?

Both a section from the report and the report are posted in the Subscriber's Area.

China has successfully developed a domestic demand driven digital economy out of nothing less than a decade ago. The introduction of social media, ecommerce, online banking, payments and saving are all contributing to the upskilling of the population.

China will scrap limit on presidential terms, meaning Xi Jinping can stay on

Thanks to a subscriber this article from the South China Morning Post which may be of interest. Here is a section:

The party has in recent decades largely observed an unwritten retirement age of 68 for its top leaders, but its charter does not have any limit on terms. That means there are no restrictions on the general secretary position, but the Chinese constitution does limit presidents to a maximum of two five-year terms.

Analysts said ending the two-term limit gives the strongest indication yet that Xi will stay in power longer than his recent predecessors at a time when the leadership was “fixated on stability”.

There was intense speculation in the lead-up to the party’s five-yearly congress in October over whether Xi would continue to lead the party beyond two terms, with some questioning whether his ambitious plans to “rejuvenate” China could be achieved within 10 years.

Governance is Everything. Does the removal of term limits represent a retrograde step? If we look at the anything beyond the short term then the answer had to be in the affirmative. Absolute power corrupts and the removal of term limits means any semblance of checks and balances will be removed. Xi has been clear that no one is above the law but China does not have an independent judiciary so that statement means nothing.

Mapping shadow banking in China: structure and dynamics

Thanks to a subscriber for this report from the Bank for International Settlements. Here is a section:

Understanding the structure of China’s shadow banking system is crucial for analysing China’s financial system. We provide a stylised map of shadow banking in China, which highlights the main forms of shadow banking and the resulting financial system interlinkages. Shadow banking in China takes a markedly different form compared to that in the United States. A key characteristic is that commercial banks are the dominant players in China’s shadow banking system. The system is effectively a “shadow of the banks”, while securitisation and market-based instruments still play only a limited role.

We show that the structure of shadow banking in China is evolving. Its size and dynamics have changed rapidly in recent years. The main area of growth has shifted from shadow credit provision to private firms with less privileged access to formal bank credit, towards offering alternative savings instruments (e.g. WMPs and trust products). Similarly, at the intermediate stage, new and more complex “structured” shadow credit intermediation has emerged and quickly has reached a large scale. This is driven by banks trying to alleviate regulatory burdens (e.g. NPL provisions or LTD ratio ceilings) through a reclassification of existing bank assets into investment receivables. Tight and growing financial sector linkages further raise the potential for the transmission of financial shocks among savers, banks and the bond market. In addition, new forms of internet-based credit intermediation, such as P2P lending, have been expanding at an extraordinary pace. As a result, shadow banking in China is growing more complex and thereby becoming slightly more similar to the US shadow banking.

We tend to hear a great deal about the problem of non-performing loans and the shadow banking sector in China. However, a point that often seems to be overlooked is that not every bank is equally affected.

A link to the full report is posted in the Subscriber's Area. I’ve been travelling to China on at least an annual basis since 2005 but it is only in the last 18 months that the pace of social change has been noticeable. Everyone is used to going to China and marvelling at the infrastructure but the social change underway with the birth of a consumer culture and domestic services industry represents a massive change for China.

US dollar policy. It really matters

The Dollar has been trending lower since early 2017 and the pace of the decline picked up pace with the approval of the Trump tax cuts. Since these measures represent procyclical policies which are the equivalent of deficit spending they have had a negative effect on the Dollar while also boosting stocks and commodity prices.

China H Share Euphoria Enters New Stage as Laggards Surge

This article by Sofia Horta e Costa for Bloomberg may be of interest to subscribers. Here is a section:

As a bull market in the China H-share gauge extends into the 715th day, one of the longest in its 23-year history, investors are finding plenty of reasons to buy and few to sell.

While technical measures suggest a pullback is overdue, growing confidence around China’s economy and earnings will support the gains for now, according to JPMorgan Asset Management’s Marcella Chow.

“It’s been a very rapid rally but only a change in fundamentals will trigger a correction and people are still quite confident,” said Chow, a Hong Kong-based global market strategist for JPMorgan Asset Management, which oversees $2 trillion worldwide. "It’s all about finding bargains.”

In such a market, any decline is seen as an opportunity to buy. When the gauge finally snapped a record 19-day winning streak on Thursday with a 1.7 percent retreat, it rebounded 2.5 percent the next day as investors pounced on the biggest losers such as banks. At the same time, persistent favorites such as China Vanke Co. and Ping An Insurance (Group) Co. show no signs of slowing down.

As a perennial underperformer itself, due to the index’s dominance by sprawling state-owned enterprises, there’s little for investors to worry about in terms of valuations. Even after an 85 percent bull run, the Hang Seng China Enterprises trades at 8.9 times its members’ projected earnings. That’s a 39 percent discount to the tech-heavy MSCI China Index, while a gauge of global equities is about twice as expensive.

The China Enterprises Index (H-Shares) has been trading at a discount to its international peers for years. However, it is the return to synchronised global economic expansion in 2017 that reignited the hunt for bargains amid valuations on Wall Street that are expensive by historical measures. At the same time, the Chinese government has been slowly but surely raising obstacles to the continued growth of the shadow banking system while the consumer economy continues to expand rapidly.

Hong Kong interest rates rise with those of the Fed. The Chinese export engine is back in fine fettle with Purchasing Managers Indices trending higher just about everywhere, but especially in Europe which is a major destination for goods. Additionally, Chinese banks trade at significantly lower multiples to their global peers. That is translating into a positive environment for the region’s banks.

China Posts First Full-Year Pickup Since 2010 on Global Tailwind

This article from Bloomberg News may be of interest to subscribers. Here is a section:

"There’s still a mountain of debt and major structural challenges to address. But compared to hard-landing fears in early 2016, and expectations of a pronounced slowdown at the start of the year, China’s economy outperformed in 2017."

In a year that began with fears of a trade war with a newly elected Donald Trump, exports turned back into a growth engine for the world’s factory floor. The contribution of net external trade to growth improved by around 0.4 percentage point in real terms last year, “more than fully explaining the pick-up” in GDP growth, said Louis Kuijs, head of Asia economics at Oxford Economics in Hong Kong.

Reflation was also key to boosting company profits and raising their ability to service debt. The GDP deflator for the full year, a gauge of economy-wide inflation, came in at 4.33 percentage points, while nominal growth accelerated to 11.2 percent. GDP in those terms grew to 82.7 trillion yuan ($12.9 trillion) -- up 8.4 trillion yuan in the year.

"Another Indonesia created in one year!" said Jim O’Neill, former chief economist at Goldman Sachs Group Inc. "The nominal GDP size confirms China has diminished the previous deflation risk and silly comparisons with 1980s Japan were just that, silly."

There is nothing quite like synchronised global economic expansion to flatter the prospects for exporters as demand increases for just about everything. That is helping China to outperform expectations and eases the burden on the economy from the efforts underway to deleverage the shadow banking system which primarily affects unlisted regional lenders.

China’s property market represents a potent source of potential trouble at some point in the future. However, it has not stopped going up, and until it does the layers of leverage that constitute every bull market will not be exposed.

Chinese Consumers Now Rule the World. Get Used to It

This article by Tracy Chen may be of interest to subscribers. Here is a section:

According to the latest official data, China’s final consumption accounted for 63.4 percent of gross domestic product (Chart 2). Household consumption experienced exponential growth and climbed to $4.5 trillion (Chart 3). Retails sales have been growing at healthy pace of about 10 percent. Spending on Singles’ Day this year (Nov. 11), is impressive, registering $25 billion, almost double U.S. Black Friday online sales of $14 billion (Chart 4).

I have mentioned on multiple occasions how much of a transformation has occurred in China over the last few years where customer service has evolved out of nowhere. Our trip to Guangzhou in July provided a number of examples of this. We used ele.me to order a fruit platter. When the person at the store saw that the delivery address was a hotel they called and asked if we would like the fruit chopped because we probably wouldn’t have a knife in our room and at no additional charge. When Mrs. Treacy was buying a phone, my girls were playing on grab machines a little way off. They were getting frustrated by their unrelenting failure to win a toy so one of the girls from the phone store came over to show them how to pick the right machine so they could win.

A $4 Trillion Reason for China's Smaller Banks to Worry

This article by Nisha Gopalan for Bloomberg may be of interest to subscribers. Here is a section:

But two things look clear: The WMP market's years of torrid growth have ended; and in an environment of higher risk, investors will prefer products sold by large state-owned lenders that are seen to be safer and of better quality.

That will put pressure on smaller banks, which have limited scope to increase lending. Minsheng, China CITIC Bank Corp., Ping An Bank Co. and China Everbright Bank Co. all had loan-to- deposit ratios exceeding 90 percent as of the third quarter, according to Francis Chan of Bloomberg Intelligence -- much higher than their bigger rivals. Shares of Minsheng and CITIC Bank have fallen in Hong Kong this year, while ICBC has jumped 27 percent.

A reckoning is approaching. As with all measures to rein in China's debt, the WMP clampdown is likely to be a stop-go process. But smaller banks will need to start looking for another source of growth, and fast.

Many of the smaller banks which have been most profligate in the use of wealth management products (WMP) are not listed. That represents a challenge in monitoring any issues they encounter using conventional stock market analysis of relative strength and leadership.

China's Banks Need More Capital After Credit Boom, IMF Says

Thanks to a subscriber for this article from Bloomberg News which may be of interest to subscribers. Here is a section:

President Xi Jinping has highlighted financial stability as a top priority. People’s Bank of China Governor Zhou Xiaochuan warned in October about the risk of a ‘Minsky moment,’ or a sudden collapse of asset values. Financial watchdogs last month promised to overhaul regulation of asset-management products, which hold about $15 trillion and are seen as a key threat to stability.

Speaking to media on Thursday on a video call, the IMF’s deputy director of monetary and capital markets, Ratna Sahay, said China’s financial system held three main risks. She pointed to an increase in credit that in other countries has been linked to financial distress. An increasingly complex and opaque financial system makes it hard to identify risks, and implicit guarantees encourage excessive risk-taking, she said.

Credit growth needs to slow, guarantees should be gradually removed, and banks need more capital during that process, Sahay said. “Banks need to have some buffers in order to protect against any possible distress that might happen,’’ she said.

Financial stability is a priority for every country and just about everywhere has its own version of implicit guarantees. We can only imagine what would happen in the USA if the now explicit guarantee behind Fannie Mae and Freddie Mac were removed. What state would the financial sector be in now if the EU and UK had not stepped in to backstop it during what was dubbed a sovereign debt crisis but was in fact a cross border banking sector calamity?

Tencent Seen Doubling by Stock-Picker Already Up 6,000%

This article by Charles Stein for Bloomberg may be of interest to subscribers. Here is a section:

Fueled by fast-growing sales, Tencent and Alibaba have almost doubled in share price this year, and both have market caps above $400 billion even after slipping recently. Their parallel climb explains in part why Leverenz’s fund has returned 31 percent in 2017, on track for its best year since 2009.

The stocks come with political risks. The Chinese government in September made creators of online message groups responsible for managing information within their forums, a move that chilled users of WeChat, Tencent’s popular social network.

“If you are an investor in Tencent you are basically betting on management’s ability to adjust to policies,” Duncan Clark, chairman of technology consulting firm BDA China Ltd., told Bloomberg News at the time.

Privately held companies will be tolerated and even prosper in China provided they accept the role of ensuring the permanence of Communist Party rule and toe the Party line. Jack Ma saying today that China benefits from the stability of a single party system can be viewed in that vein. “Private” companies are increasingly organs of central propaganda and are expected to assist both in monitoring and influencing the public.

Copper Falls to 2-Month Low on Worries of Slowing China Demand

This article by Yuliya Fedorinova for Bloomberg may be of interest to subscribers. Here it is in full:

“Industrial metals prices will consolidate due to a marked slowdown in China’s metals consumption growth,” BMI Research wrote in an emailed note.

China’s frenzied construction of roads, bridges and subways is set for a major slowdown, adding a headwind to economic growth in 2018. Fixed-asset investment in infrastructure will grow 12 percent next year, according to the median estimate in a Bloomberg survey, down from almost 20 percent in the first ten months this year.

All 18 economists in the survey anticipated a moderation, adding to reports by Morgan Stanley, Goldman Sachs Group Inc. and UBS Group AG predicting a similar trend.

Adding to the selloff is speculation that metals prices have overshot fundamentals in the recent run up. Nickel has retreated 13 percent since early November, giving up some gains from earlier in the year.

"The recent rally in nickel was mostly due to expectations of increased use of the metal in batteries, which will definitely realize some day, but right now stainless steel, not EVs, is still major consumer of nickel and its market driver," Boris Krasnojenov, an analyst at Alfa Bank in Moscow, said by phone.

China has infrastructure on par with many developed countries and has more spare steel capacity, for example, than the entire industries of Japan, South Korea and Taiwan combined. At some point there will be a rationalization of that industry. However the big question is what will replace it?

“Institutional investors are choosing to cash in toward year-end as valuations are near historic highs and market sentiment deteriorated after official media targeted Moutai,” said Shen Zhengyang, Shanghai-based analyst at Northeast Securities Co. He said the market “lacks steam” for further gains.

The pace of the CSI300’s advance has picked up over the last six months and has outperformed the bank-heavy Shanghai A-Share Index. The institutional memory of the bubbly activity which contributed to the surge and collapse of the market in 2015 is still relatively fresh and the government does not want to see a repeat. That suggests some pressure may be coming to bear on the highest-flying shares, to instil some discipline among investors.

After Sudden Rout, China Stock Traders Question Beijing Put

This article from Bloomberg News may be of interest to subscribers. Here is a section:

For Sun Jianbo, president of China Vision Capital Management Co. in Beijing, valuations among large-cap shares are too expensive for state-backed funds to intervene.

The CSI 300 traded at its highest level relative to the broader Shanghai Composite Index in at least 12 years at the start of this week as investors flocked to large caps such as Moutai and Ping An Insurance (Group) Co.

"There’s no need to prop up the market yet," Sun said. "A lot of big caps are still expensive and it would do more harm than good to state-backed funds if they buy now."

The divergence between large-cap shares and the rest of the market may be one reason why the government took aim at Moutai. Before Xinhua warned last week that gains in the liquor maker were excessive, the stock had more than doubled this year.

Following the botched introduction of options trading in 2015 the Chinese administration introduced new rules on disclosures and selling by company principles. It also banned short selling for a time. Through steady purchases by various state-owned vehicles, they manufactured the slow and steady pace of the stock market’s advance since the low in early 2016.

One in three Chinese children faces an education apocalypse. An ambitious experiment hopes to save them

This article by Dennis Normile for Sciencemag.com may be of interest to subscribers. Here is a section:

One in three Chinese children faces an education apocalypse. An ambitious experiment hopes to save them – This article by Dennis Normile for Sciencemag.com may be of interest to subscribers. Here is a section:

The result is a widening gap between urban and rural educational achievement in China, Rozelle says. Many urbanites fit the stereotype of "tiger" parents, pushing kids to excel in school. After hours, their schedules are packed with music and English lessons and sessions at cram schools, which prepare them for notoriously competitive university entrance exams. More than 90% of urban students finish high school.

But only one-quarter of China's children grow up in the relatively prosperous cities. Rural moms have high hopes for their children; Rozelle's surveys have found that 75% say they want their newborns to go to college, and 17% hope their child gets a Ph.D. The statistics belie those hopes: Just 24% of China's working population completes high school.

Rozelle believes such numbers bode ill for China's hopes of joining the ranks of high-income countries. Over the past 70 years, he explains, only 15 countries have managed to climb from middle- to high-income status, among them South Korea and Taiwan. In all those success stories, three-quarters or more of the working population had completed high school while the country was still in the middle-income bracket. These workforces "had the skills to support a high-income economy," Rozelle says. In contrast, in the 79 current middle-income countries, only a third or less of the workforce has finished high school. And China is at the bottom of the pack. School dropouts don't have the skills needed to thrive in a high-income economy, Rozelle says. And, worryingly, the factory jobs that now provide a decent living for those with minimal training are moving from China to lower-wage countries.

Rozelle thinks a lack of opportunity isn't the only factor holding back China's rural children. Physically and mentally, they are also at an increasing disadvantage, hampering their performance in school and their prospects in life.

You might remember last year the OECD’s Pisa rankings of schools was released and China featured particularly highly. That is because the data only looked at Beijing, Shanghai, Guangdong and Jiangsu where the best of the country’s education resources are concentrated. As the above article highlights the real story is of a country that still has a long way to go in equipping its population with the tools necessary to succeed in the 21st century.

Stronger enforcement, improving cashflow

Thanks to a subscriber for this report from Deutsche Bank focusing on the Chinese Environmental sector. Here is a section:

The sector’s valuation looks attractive at current levels compared with its own trading history and also with the index. The P/Es of most stocks are below/close to their average minus one standard deviation since 2015, in terms of both their own PE and also relative PE to MSCI China. We think that the sector’s current valuation offers decent safety margins to buy into most stocks.

China usually strengthens environmental enforcement during the last three years of Five-Year Plan periods as the country gets closer to assessment deadlines. We expect the same to take place from 2018, especially as the CPC's 19th National Congress recently mentioned that China plans to set up a "National Natural Resources and Ecology Administration" soon. We expect these factors to benefit this laggard sector, together with improving cashflow profile/earnings quality with selective companies over the next few years

By all accounts New Delhi’s pollution is quickly catching up with Beijing’s but China is further along on its development track that India. The thick soup of smog that clings to Northern China during the winter is a political liability as the middle class evolves and demands better conditions. The closing down of inefficient production facilities and fabricators is driven both by a desire to cut back on overcapacity and to tackle nonperforming loans. Improving the environment at the same time is a bonus.

Foreign Banks Invited to End of the Credit Party

This article by Tom Orlik for Bloomberg may be of interest to subscribers. Here is a section:

In the 2000s, China invited foreign banks into the domestic market, as it tried to manage down a legacy of bad loans. HSBC bought a share of Bank of Communications, Royal Bank of Scotland took a minority stake in Bank of China and Bank of America purchased a piece of China Construction Bank – helping them on their way to listing. Fast forward to 2017 and the bang is bigger. Based on an announcement Friday, limits on foreign ownership of Chinese banks and asset managers will be removed, and foreign firms will be able to take a 51% stake in securities and life insurance firms. But the aim is the same – helping clean up a financial mess, and prevent it from happening again.

Bloomberg Economics had flagged financial market opening as one of the possible deliverables from this week’s U.S. - China summit. Recognizing that the devil will be in the as-yet-unknown details, here’s our take on the implications:

There’s potential for a grand bargain here. China’s financial system will receive an influx of foreign capital and expertise.

That will help deal with the aftermath of a credit binge that has seen debt swell to 259% of GDP, and engineer efficiency gains that may help prevent a repeat occurrence. After paying the price of entry, foreign firms will get a piece of the Chinese market – the second largest and fastest growing in the world.

China has taken on a great deal of debt over the last couple of decades as the pace of infrastructure development has beaten all records. Quite what to do with it is a big question and there are three answers. However, perhaps the biggest takeaway is that the administration is taking substantive measures to tackle the problem.

Xi Jinping Unveils China's New Leaders but No Clear Successor

This article by Chris Buckley for the New York Times may be of interest to subscribers. Here is a section:

The five new Standing Committee members are party leaders with long careers in Chinese politics, including one of Mr. Xi’s longtime allies and a scholar of international relations. But the party declined to name a younger leader to the committee who might succeed Mr. Xi when his second term as president ends in 2023.

That was a departure from China’s carefully scripted transfers of power in recent decades and a possible signal that Mr. Xi intends to govern beyond this next five-year term. Mr. Xi may also want more time to test possible successors, while avoiding lame duck status with an heir waiting in the wings.

But by discarding the unspoken conventions that have ensured relatively stable leadership changes in recent years, Mr. Xi has pushed Chinese politics into new territory that critics have warned could lead to turmoil, or a cult of personality with echoes of Mao.

“If Xi goes for broke and breaks precedent by not preparing for an orderly and peaceful succession, he is putting a target on his back and risking a backlash from other ambitious politicians,” Susan L. Shirk, the chairwoman of the 21st Century China Center at the University of California, San Diego.

“By taking such a risk, he shows himself to be more like Mao than we originally thought — he demonstrates his power by overturning institutions,” said Professor Shirk, a former State Department deputy assistant secretary for China policy.

Xi Jinping is 64 years old which means he will be older than the “unofficial” retirement age of 68 when the next Party Congress is next held in 2022. He has not anointed a successor so there is going to be a hiatus in promotions for ambitious party cadres over the next five years. Meanwhile the trajectory of his rule points towards his desire to extend his tenure beyond two consecutive terms.

Xi's China a boon for mining

This article from mining.com may be of interest to subscribers. Here is a section:

And Xi's enormous power also means his pet projects should receive the full backing of the state.

The One Belt One Road initiative to recreate the Old Silk Road connecting Asia with Europe was mentioned five times during the speech. (Mao Zedong and Deng Xiaoping received four mentions each)

Another mega-undertaking, Beijing-Tianjin-Hebei integration, which includes the Xiongan New Area, Xi mentioned twice.
And even if the party's priorities are shifting away from market-orientated reforms, Beijing's transformation of its heavy industries coupled with programs to fight pollution has already benefitted mining.

For instance, eliminating overcapacity has boosted profitability in the domestic steel industry and in the process steelmaking raw material prices have been dragged higher. At the end of last year consensus forecast for the iron ore price was $57 a tonne during 2017. Year-to-date it's averaging $71.

Building new cities is nothing new for China but the Xiongan New Area will move the administrative hub from central Beijing to a new city which will remove a substantial number of people in one fell swoop. This also means that the new city will need to be both architecturally secure and technologically capable enough to house one of the world’s largest and most ambitious bureaucracies.

Email of the day on China's yield curve

Thank you for such an eloquent financial service! Further to your comment on China today, according to Tracy Alloway of Bloomberg, the Chinese 5-10 Yield curve inverted yesterday. Is this a bad omen or can China be different!?

Thank you for your kind words and this email which may be of interest to subscribers. The Chinese yield curve is inverted between the 5 and 10-year maturities but, generally when we talk about the yield curve spread, which is what I believe you are referring to, we look at the difference between the 2 and 10-year maturities.

Xi Skips Old Growth Pledge as China Seeks Quality Not Quantity

This article from Bloomberg may be of interest to subscribers. Here is a section:

"China’s policy makers are likely to tolerate growth to have another leg down to 5 to 6 percent in the next five years, so that they could have bigger room to fix the structural problems and make growth more sustainable," Hu wrote.

That’s in line with earlier messages of tolerance of slower growth in exchange for stable development. Xi told a meeting of the Communist Party’s financial and economic leading group last year that China doesn’t need to meet the objective if doing so creates too much risk, Bloomberg News reported in December.

Xi’s speech, which ran for more than three hours and mapped out a grand strategy for China’s development by 2050 implies "a change in growth and development objectives," said Chen Xingdong, chief China economist at BNP Paribas SA in Beijing.

The party is seeking to share "growth and prosperity for the majority of people through reformation of income distribution," Chen said

The larger an economy becomes the more difficult it is to sustain double digit growth rates. China is a perfect example of this and its size is a clear example for why smaller economies like India or the Philippines are currently outpacing its expansion.

Macro Morsels

Thanks to a subscriber for this edition of Hardings report for Maybank which today includes a section by Russell Napier. Here is a portion:

While developed world central bankers claim and deserve some credit for saving the world from a depression in 2009, their colleagues in the emerging markets may also have been key players in staying disaster. As OECD broad money growth actually contracted in late 2009, China saw broad money growth around 30% and India around 20%.

Could this have been a key factor in preventing a debt deflation? If so, we need to be concerned that as broad money growth in the OECD slows rapidly the growth of broad money in India and China has reached new lows.

In China M2 growth year on year, at 8.9%, is the lowest level of growth recorded since records began. That is a marked slowing from the growth rate of above 11% when the world thought Chinese growth was collapsing in 1Q 2016. That tightening in monetary policy occurs as three-month interest rates in China have risen from a low of 2.7% in 2016 to 4.7% today.

China is attempting to clamp down on property market speculation as prices continue to climb. That could well be behind the slow pace of money growth. However, it is also worth considering that the cuts to reserve requirements on its banks announced Wednesday were designed to act as some incentive to increase money supply

The Hong Kong Financials Index, which is comprised primarily of mainland banks and insurance companies, continues to outperform the China Enterprises (H-Share) Index. The 4000 level has acted as an area of psychological resistance since 2008 and it rallied above it on Wednesday. A break in the progression of higher reaction lows would be required to question medium-term scope for additional upside.

The Shanghai Property Index pulled back sharply before the mainland market closed for the Mid-Autumn festival and is now testing the region of the trend mean and the progression of higher reaction lows. It will need to bounce soon if potential for higher to lateral ranging is to be given the benefit of the doubt.

Russell Napier’s contention that risk is growing in the financial sector is far from a lone voice in the wilderness and there is some weight to the argument however if we assess the consistency of trends across global markets there is scant evidence of top formation development, at least right now.

Baidu Invites China's Cybercops to Label, Rebut Fake News

This article from Bloomberg News may be of interest to subscribers. Here is a section:

The platform links 372 police agencies who will use sophisticated artificial intelligence-driven tools to monitor and respond to fake news, blogposts and other items across about a dozen Baidu services, including the popular search engine, the official Xinhua News Agency reported. More than 600 organizations and experts in different areas will be enlisted to weigh in on their respective fields, according to an email sent by Baidu. They included official organs such as the Chinese Academy of Social Sciences, as well as media outfits such as Shanghai United Media Group and Caijing.

Internet giants from Facebook Inc. to Twitter Inc. are struggling to deal with a proliferation of spurious news articles across social media services. Baidu’s approach allows the Chinese government to intervene directly and write articles in rebuttal. Items that its system decides are fake will be clearly labeled a “rumor” at the very top of search results, alongside an explanation penned by the relevant agency or organization, according to a sample page Baidu provided.

One of the reasons companies like Alphabet and Facebook cannot gain access to China’s market is because they are unwilling to acquiesce to the demands the central government makes in terms of unfettered access to user data. Domestic Chinese companies do not have the luxury of choice.

There were a number of interesting points raised but I believe the most relevant for subscribers’ centre on what he said about shrinking the Fed’s balance sheet, the outlook for the Dollar, commodity markets, the relative attractiveness of emerging markets and his best guess for when to expect the next recession.

Email of the day on Chinese customer service

My first experience of Shanghai customer service was in 1987. One afternoon we were bussed around the local Friendship Stores to spend money; but, I was having no more of it and took my camera to get some shots of real locals rather than Communist Party guides! My broken Mandarin got me an invite to join some locals at a table for food and beer. I politely declined the offer of food but said I would indulge in a beer. Unfortunately, the glass had a viral bug on it which 2 hours later caused my anatomy to require plenty of boiled eggs to help reverse my problem! We were staying at a hotel on The Bund. At 5pm we asked for room service and requested lots of boiled eggs on toast, only to be told, sorry, we only serve eggs at breakfast time! 30 years ago, Customer Service was unheard of.

While in China this summer I was amazed at the improvement in customer service that has come about as a result of the online review system available via many different social media services. The fear of receiving negative reviews has literally changed behaviour beyond recognition in service establishments.

China Is Said to Draft Plans for Financial Sector Opening

This article from Bloomberg News may be of interest. Here is a section:

As part of an early package of reforms agreed between the two leaders, Beijing agreed in May to allow U.S.-owned card payment services to begin the process of obtaining local licenses, in a move that would erode the near-monopoly held by China UnionPay Co.

Chinese regulators last year decided to open up the nation’s fund market, allowing investment firms in China to be 100 percent owned by foreign managers. At least a dozen global money managers such as Man Group Plc, Bridgewater Associates and Fidelity International have announced plans since then to start private securities funds. Before the rule change, foreign firms were restricted from running such private funds in China but could take stakes in mutual fund companies and provide advice to onshore funds.

The most basic premise of insurance is to pool risk among as wide a grouping as possible to minimise the exposure any one individual takes on. Taken from that perspective the timing of the decision by Chinese officialdom to begin allowing foreign investors access to its capital markets is interesting.

Email of the day on Chinese online retailers and online universities

– Thank you for these questions which may also be of interest to the Collective. I reviewed the online retail sector when I was in China in July. It has developed considerably since my last visit two years ago together with online payments, banking and same day delivery services. Here is a link to comment of the Day on July 25th.

The Fat Tech Dragon

This report by Scott Kennedy for the Center for Strategic & International Studies may be of interest to subscribers. Here is a section:

China’s embrace of intellectual property (IP) is highly positive when contrasted with the country’s original disdain for property rights of any sort and widespread violation of IP rights. However, China’s efforts to develop and obtain more IP is driven heavily by bureaucratic imperatives as opposed to market incentives. Moreover, China may now be a “large” IP country, but it is still a “weak” one. Whether one is discussing licensing and royalties, mergers and acquisitions, or dispute settlement, Chinese patents still have little commercial value.

China’s commercial success has outstripped its progress in technology innovation. Chinese companies are acquiring greater market share in high tech, particularly in the most commodified segments of sectors. The value-added contribution to manufacturing is growing in absolute terms, and domestic companies are contributing a growing share to China’s high-tech exports.

Overall, China’s high-tech drive may be characterized as “good-enough innovation.” From a negative perspective, China is investing—and may be wasting—a great deal of human capital and funding, but is still far from a leader in high tech. From a more positive perspective, China is achieving incremental progress by benefiting from its strong capacity in manufacturing, the accumulation and diffusion of tacit knowledge, and the opportunities provided by such a large market.

Regardless of the level of support they receive from their government, Chinese companies will face growing challenges in their interactions with multinational businesses and in overseas markets. Foreign governments and multinational businesses likewise need to decide how to strategically respond to China’s approach. They could take a firm stand in opposition, try to influence China’s approach at the margins, or go along with the strategy as best they can. In any case, if they are not careful, they could end up under the heavy foot of a fat tech dragon.

In addition to its race to become a centre for high tech innovation China is also intent on a “China first” policy of making sure it is producing its own semiconductors without having to rely on US, Japanese, Taiwanese and South Korean manufacturers. That raises important questions about M&A activity since so much of it is state sponsored. The reality is that if China gains the technology to produce its own semiconductors it will seek to flood the market with cheap products and that could represent a significant issue for the global tech ecosystem.

Navigating China's post-congress landscape

This article by Ryan Hass for Bloomberg may be of interest to subscribers. Here is a section:

Over the past five years, the Chinese leadership’s top priorities have proven extremely consistent, reflecting a consensus on broad goals. The leadership has remained steadfastly focused on strengthening the Communist Party, safeguarding stability, and enhancing China’s regional leadership and global standing. There have been changes to the manner in which Xi has centralized power and the party has headed off domestic and external challenges. But on the top priorities, the party has followed consistent north stars to guide policy.

To this end, the Chinese leadership will continue to emphasize financial and economic stability and guard against financial shocks. Particularly with the much-anticipated centenary of the founding of the Communist Party in 2021, Beijing will be determined to achieve its goal of becoming a “moderately well-off society,” which in practical terms means doubling per capita income and national gross domestic product from 2010 levels.

Over the past five years, when confronted with choices between greater control and greater openness to innovation, China’s leaders consistently have opted for the former. Expect economic policies to continue favoring state control and stability, even at the cost of some economic growth. This bias is likely to extend to policies related to the internet and social media, where heightened censorship over the past five years has demonstrated the leadership’s wariness of losing control of information in the digital age.

Political machinations are going into overdrive to ensure stability in the Communist Party’s handover of power to a new generation at the upcoming Congress. No fewer than five of the Standing Committee’s members are to be replaced while 40% of the wider Politburo are retiring as well.

Chinese automakers covet FCA

This article by Larry Vellquette for Automotive News may be of interest to subscribers. Here is a section:

Why, after two years on the block, is FCA apparently drawing interest from at least one potential Chinese buyer now?
The answer: FCA's global network and product — specifically Jeep and Ram — fit the requirements the Chinese government has set for attractive acquisitions.

Quality gap
Chinese automakers have openly dreamed of cracking lucrative North America for a decade, spending millions to display their vehicles at high-profile U.S. auto shows. Early efforts showed that Chinese automakers had a long way to go before they were ready to compete here.

But in more recent years — through knowledge and expertise gained via joint ventures with the world's largest and most successful automakers — Chinese companies have closed the quality gap.

And the automakers feel like they finally have closed that gap enough to start selling their products in the U.S., said Michael Dunne, president of Dunne Automotive, a Hong Kong investment advisory company and an expert on the Chinese auto industry.

They also are under pressure from the government to expand beyond China, Dunne said. A government directive dubbed China Outbound pushes Chinese businesses to acquire international assets from their industries and operate them "to make their mark," much as Geely has done since acquiring Volvo in 2010. Bloomberg reported last week that Chinese companies plan to spend $1.5 trillion acquiring overseas companies over the next decade — a 70 percent increase from current levels.

Germanys auto sector has been garnering all the wrong sorts of attention lately with increasingly evidence that the major manufacturers may have colluded in hoodwinking the globe into believing diesel engines are clean. On the other hand, China’s auto manufacturers have been among the best performers this year as they have increasingly focused on partnerships with international brands.

This article by Bradley Keoun for The Street may be of interest to subscribers. Here is a section:

While China still keeps an iron grip on its exchange rate, 2017 has thus far brought a reversal of a three-year stretch in which the dollar weakened against the yuan, also known as the renminbi or by its trading symbol RMB.

Some of the Chinese currency's strength stems from appreciation in major currencies like the euro and yen against the dollar, putting upward pressure on the yuan on a trade-weighted basis. But the gains versus the dollar show a willingness on the part of China to cede a marginal advantage to the U.S., its biggest single destination for exports.

"We do expect that the RMB should continue to gradually strengthen versus the weakening dollar over the next few years," said Jan Dehn, head of research at London-based Ashmore, which specializes in emerging-market stocks and bonds.

The exchange-rate reversal comes amid increased tensions between Trump and Xi, who has taken steps to improve his country's standing as a powerhouse in international trade even as the U.S. president pledges to renegotiate trade deals he considers unfair -- in order to protect American manufacturers and workers.

Greece couldn’t get a deal on debt restructuring until after the German election so that Merkel could further cement her place as the nation’s longest serving Chancellor. The rush to get deals done with Cuba and Iran in the last 18 months of Obama’s administration were equally aimed at legacy building. It’s plain for anyone to see that politicians care about their legacy and go to rather extreme lengths to get the headlines they want. Why should China be any different?

Chinese investors have bought about 35 billion yuan ($5.18 billion) worth of Hong Kong stocks in July as of Friday, surpassing June’s total monthly net purchases according to Bloomberg calculations.

“Mainland investors are buying Hong Kong stocks to diversify their portfolios and hedge risks, thanks to the weak performance of mainland equities, especially the ones listed in Shenzhen," said Banny Lam, managing director and head of research at CEB International Investment Corp.

The ChiNext, cowed by an official battle against speculators, is on the verge of becoming cheaper than the Nasdaq Composite Index for the first time on record. Its valuation based on reported earnings is now at 36.2, compared with 34.3 for the Nasdaq, leaving the narrowest gap since the Chinese board started in 2010.

The upcoming Party Congress slated for September or October represents a pivotal transition for the Chinese administration. This event is more important than any in at least the last fifteen years because so many members of the Politburo and Standing Committee have reached retirement age. It represents a key opportunity to cement power for the existing team by appointing their own people into key positions of power they could occupy for the next decade.

Copper price jumps on gangbusters China growth

This article by Frik Els for Bloomberg may be of interest to subscribers. Here is a section:

Copper futures trading on the Comex market in New York jumped on Monday on renewed optimism about economic strength in top commodity consumer China.

Copper for delivery in September jumped to a high of 2.7375 a pound (just over $6,000 a tonne) in lunchtime trade, up 1.7% on the day to the highest level since end-March. LME copper's 2017 year to date gains in percentage terms are now within shouting distance of 10%.

Commodity-intensive sectors continue to expand at a faster rate than the broader measure of industrial production

The economy of China, responsible for nearly half the world's consumption of copper, expanded at an annual rate of 6.9% in the second quarter against expectations of a slight decline and at a quicker pace than Beijing's own target of 6.5% growth for 2017.

In seasonally-adjusted quarter on quarter terms, growth was even more significant, picking up from 1.3% to 1.7%. If the trend continues, this year would be the first time since 2010 that the Chinese economy grew faster than the year before.

Industrial production data for June released today also pointed to a significant improvement. Growth in industrial output picked up from 6.5% year on year to 7.6% led by greater electricity and steel production. Bloomberg consensus forecasts pointed to no acceleration for Chinese industrial output.

China has a major political transition coming up in September or October. Xi Jinping has not yet anointed a new successor probably because so many positions are opening up in the Standing Committee and the Politburo, and he has a vested interest in stacking them with his own appointees.
The ousting of Sun Zhengcai, a current Politburo member, from Chongqing over the weekend supports the view Xi is angling towards the kind of control Zhang Zemin had over the political apparatus which persisted long after he was in the top position.

Talk of containing “grey rhinos” or in Donald Rumsfeld speak “known knowns” can also be viewed as an attempt to ensure Xi’s legacy. Here is a section from an article discussing the issue from Bloomberg:

"The message from the leadership last weekend was very clear -- financial stability is now regarded as an important element of national security," said Raymond Yeung, the Hong Kong-based chief economist at Australia & New Zealand Banking Group Ltd.

An editorial in the Communist Party’s People Daily newspaper on Monday pointed to the seriousness of the campaign, warning of potential "grey rhinos" -- a variation on the black swan events popularized during the global financial crisis, with the difference that the danger from a charging rhino is more immediate and the animals are less rare.

Bitcoin Split Risks Increase

This article by Andrew Quentson for Bloomberg may be of interest to subscriber subscribers. Here is a section:

As such, we are likely to have at least two bitcoins on August the 1st, but there may be even more. Bitcoiners, therefore, are strongly advised to not transact on that day until the situation becomes more clear.

Once the chain does split, BitcoinABC will probably be listed in at least one exchange, thus a period of high volatility and perhaps even trading frenzy should be expected as the market passes judgment on the value of the bitcoins.

Eventually, the dust will likely settle with one coin probably gaining some 80% or so of the current bitcoin value, while the minority coin can continue operating in their own network, free to follow their own roadmap and vision.

Which one will be which only the free market can tell us sometime next month as bitcoin finally makes a monumental and probably highly historical decision, at least for this space.

Bitcoin was set up so that no more than 21 million coins could ever be mined. More than 16 million have already been created, with the complexity of each successive block growing progressively more expensive to solve. With bitcoins already priced out to 6 decimal places that limitation has asked legitimate questions about the sustainability of the global market when supply is so limited. That has led to a debate between monetary purists and miners who want to support the value by withholding supply and others who wish to see dynamic supply to allow the market to grow.

China shares get MSCI nod in landmark moment for Beijing

This article from Reuters may be of interest to subscribers. Here is a section:

Inclusion in the index marks a key victory for the Chinese government, which has been working steadily over the past few years to open up its capital markets, investors said.

"Given the size and importance of China as an economic superpower, I think this is a historic moment," Kevin Anderson, senior managing director of State Street Global Advisors and head of investments in the Asia Pacific region told Reuters.

"It's a long-awaited and much-debated decision in the past, and I think it's more than symbolic as it will create additional flow of capital and potentially a new segment of institutional investors in the China market."

Traders said MSCI's widely expected "Yes" decision had been largely priced in, with the announcement triggering some profit-taking in blue chips, which are no longer cheap after strong rallies this year.

MSCI admitting mainland Chinese shares to the Emerging Markets Index is a major event for China since it has been campaigning for entry for years already. However if we look at what the composition of the new Index is going to be then China does not get a much larger foothold. What the decision does create is the option for MSCI to include mainland shares but it would have to be at the expense of overseas listed shares which have clearly outperformed over the last year and more.

China Banks Endure Record Costs as Squeeze Leaves No Choice

This article from Bloomberg News may be of interest to subscribers. Here is a section:

When cash supply tightens, small- and medium-sized lenders are usually among the hardest-hit because they lack the retail deposit arsenal of larger banks, said Yulia Wan, a Shanghai- based banking analyst at Moody’s Investors Service. They also may not have enough bonds to use as collateral to borrow money in the repo market. The banks need the money to finance longer- term and less liquid assets, such as debt and investment in loans and receivables, she added.

The PBOC has begun to take note of the stress on the financial system.

The monetary authority has injected a net 160 billion yuan through open-market operations this week, the most since the five days through May 19. The central bank-run Financial News said on June 10 that the “abnormal market swings” of June 2013 won’t happen again -- a reference to a record cash crunch four years ago.

Still, China’s seven-day repurchase rate -- the money- market benchmark -- has averaged 2.74 percent so far in 2017, compared with 2.32 percent a year ago. The gauge climbed four basis points this week to 2.95 percent, while the one-day rate rose three basis points to 2.86 percent.

“Some lenders don’t have better sources of funding to replace NCDs,” said Moody’s Wan. “Issuing such debt at such a high price will have a negative impact on their profitability.”

There is a lot happening in the Chinese financial sector right now. First off there is an official drive to contain speculation. The question is why now? Leverage, speculation and infrastructure development, all backed by government support, have been part and parcel of China’s economic growth model for decades. The question now is why is it such a problem today? I can think of two answers.

Demographically challenged

Thanks to a subscriber for this report from Deutsche Bank which may be of interest. Here is a section:

A deep dive into demographics suggests a dire outlook for property prices
Following an in-depth demographic study for Hong Kong, we have turned more negative on housing demand. Taking into account weaker demand and rising supply (we published a FITT report on supply in Sept-16) we have cut our medium-term (2018E-21E) residential price forecasts significantly. We now expect vacancy to surge to 9% (4% now) and ASP to slide 48% by 2026 from current levels. We reiterate our view that developers will be forced to change their business model from land-banking to asset turnover. Hence, we overhaul our valuation methodology from discount-to-NAV to SOTP, using P/E to value development businesses. We downgrade HLD, Kerry and NWD to Hold.

Several negative demographic trends
In this report, we identify several notable demographic trends in Hong Kong, with the most significant being: 1) natural population growth has already peaked and is likely to turn negative by around 2027; 2) reduced immigration; 3) the quick shrinkage of the 25-44 years age group to 26% of the total population by 2025, from 38% in 1995 (vs. 29% now); 4) the rise in people aged over 60 years to 30% of the total population, from the current 22%. Hong Kong already has the second-highest over-60 population in Asia, as a percentage of total population, behind Japan.

Aging population constrains financing, translating into lower affordability
In our view, housing affordability will be severely affected by an aging population. We believe affordability (debt servicing) is a function of property prices, mortgage rates, loan tenures and income. As the population ages, fewer households will be able stretch their mortgages to the maximum tenure of 30 years. On our new estimates, we expect only 11.5% of total households will be able to afford an average private housing unit by 2019. Moreover, by factoring in upcoming rate hikes, we expect overall affordability to worsen and ASP to decline by 48% over 2017-26 to restore the supply/demand equilibrium.

A new valuation methodology for property development – P/E approach
With improving supply and a bleak outlook for the physical market, we expect land-banking to fade as a business strategy, and we anticipate a growing focus on asset turnover. As a result, we believe a discount-to-NAV valuation methodology will become less relevant in valuing the developers, and we advocate adopting a P/E approach for the development businesses. For the investment properties owned by the HK Property companies, we continue to estimate NAVs based on cap rates. We then apply a discount to the investment property NAV of 34% (the average discount over the past 25 years).

Hong Kong has long defied sceptics in its ability to innovate and adapt to changing market structures. However that has not freed it from the cyclicality of the property market which has always been prone to boom and bust. With a pegged currency and interest rates that are beginning to rise from a very low base, the threat to property prices, which are at elevated levels, is growing.

China's Markets Get a Double Dose of Caution From Moody's, MSCI

This article by Chris Ansley and Enda Curran for Bloomberg may be of interest to subscribers. Here is a section:

Moody’s Investors Service unveiled a surprise downgrade of China’s sovereign credit rating, citing concerns about its continued buildup of debt. Earlier, the head of one of the world’s top stock-index compilers suggested China had more work to do to get its onshore stocks into emerging-market gauges. With a June 20 deadline looming, “there’s still a lot of issues to resolve,” MSCI Inc. Chief Executive Officer Henry Fernandez said.

Underlying the critique from both: issues stemming from the Chinese leadership’s preoccupation with control. Few analysts expect painful reforms to be unleashed ahead of the Communist Party’s leadership reshuffle due later this year. While officials preach the need to rein in credit, ensuring the economy hits a 6.5 percent growth target remains the top priority.

Trying to lean on the shadow banking sector, while also stimulating the economy is a tough goal while also achieving an outsized growth rate. However it is also worth considering that only about 12% of China’s debt is held externally. The caveat of course is that a good portion of that has been raised by property developers recently through US Dollar bond issuance.

Macro Morsels on China

Thanks to a subscriber for this report from Maybank which may be of interest. Here is a section:

Chinese authorities are attempting to delever their excessive levels of DEBT, which is causing a lack of credit at the short end of the curve, which in turn is driving up the cost of borrowing money at the short end.

Hence , short rates are higher than long rates.

However, unlike in the West, where an Inverted Yield curve signals trouble to the economy and to equities, having an Inverted Yield Curve is NORMAL in China.

This Inverted Yield Curve has been the situation for the majority of the last decade.

The red shaded area shows the times when 3 Month SHIBOR has been above 10 year government yields.

Currently the 3 Month SHIBOR is at 4.44%, higher than the 10 year at 3.61%

The AA 5 year rates have moved quite dramatically since last Oct, from a yield of 3.6% to 5.6% now.

This rise in their cost of debt should be negative for Equities.

Equities (SHCOMP) have indeed broken their uptrend and will remain an avoid until they can regain the 3200 level.

China’s wide divergence between lending and deposit rates as well as the de facto state control of the banking system tend to skew financial conditions so that while an inverted yield curve is an omen of stress in the West, it is apparently less of a factor in China.

China Stocks Still Adored Abroad as Losses Mount for Locals

This article by Sofia Horta e Costa for Bloomberg may be of interest to subscribers. Here is a section:

Mainland markets have struggled under the government’s campaign to trim risk in the financial sector, making stocks the least linked to the offshore index since 2006. With history showing sentiment can flip quarter to quarter, international traders are riding on a bet that solid corporate and economic data will continue to support the divergence.

“These investors don’t believe that any of this will lead to a crisis,” said Caroline Yu Maurer, the Hong Kong-based head of Greater China equities at BNP Paribas Investment Partners.
“For stocks, people are buying earnings growth rather than macro stories. The market is quite resilient as long as that holds.”

For a gauge that is rarely this expensive relative to the rest of the world, improving earnings are emerging as a key line of defense against worsening sentiment. While profit estimates are being upgraded at the fastest pace since 2010, they’re failing to keep pace with the index’s rally, which has pushed valuations toward the highest levels since 2015. The gauge gained another 0.4 percent on Wednesday, while the Shanghai Composite slumped 0.9 percent to its lowest level since October.

The mainland Shanghai Composite is heavily weighted by state owned enterprises like banks and infrastructure companies which are the primary focus of the clamp down on the shadow banking sector and financial leverage in “private lending clubs”. Privately owned companies, many of which are listed in Hong Kong or the USA continue to perform not least because they are not overly impacted by the financial sector tightening currently underway.

Buying Spree Brings Attention to Opaque Chinese Company

This article by David Barbozamay for The New York Times may be of interest to subscribers. Here is a section:

Last week, HNA was the subject of wild online speculation after a fugitive Chinese billionaire said in a television interview that relatives of a senior Chinese leader, Wang Qishan, had a stake in the company. No proof was provided.

The allegations leveled by the billionaire, Guo Wengui, who has ties to China’s former spy chief, is part of his broader war on the Chinese government. From his New York apartment, Mr. Guo, using his Twitter account and Google’s YouTube, has been making claims of widespread government corruption. China has requested his arrest, on separate corruption charges.

As speculation swirled that HNA could be drawn into a political firestorm, shares of one of the company’s Hong Kong affiliates tumbled late last month. Soon after, critical news articles on the group began disappearing from Chinese websites, prompting concerns that government censors had handed down orders to delete unfavorable news about HNA.

Mrs. Treacy has been following this story closely. Guo’s interview on Voice of America’s Chinese channel in late April, which had been headlined as an exposé, was cut short when Chinese officials called the show directly to insist it be cut off. Here is a section from an article discussing the event:

Big Short in Loonie on Concern Over Oil, Trump, Housing

This note by Maciej Onoszko for Bloomberg may be of interest. Here it is in full:

Hedge funds and other speculators increased their short positions in the Canadian dollar to the highest level on record, according to data from the Commodity Futures Trading Commission. The loonie, which is the worst-performing major currency this year, has been under pressure in recent weeks amid concerns over a potential trade war with the U.S., a plunge in crude oil and financial woes of alternative mortgage lender Home Capital Group Inc.

The Canadian Dollar skirted the worst effects of the credit crisis by virtue of having a strongly regulated banking sector when just about everywhere else in the G7 had given into the worst excesses to deregulation. The rebound in oil allowed the Loonie to retest its 2008 peak in 2011 but the subsequent decline in commodity prices has taken its toll.

Can the Synchronous Recovery Last?

Thanks to a subscriber for this report from Morgan Stanley which has a number of interesting nuggets. Here is a section:

For the first time since 2010, the global economy is enjoying a synchronous recovery (see chart). The developed markets’ (DM) private sector is exiting deleveraging after several years of slow growth due to a focus on balance sheet repair and, after four years of adjustment, the emerging markets are in a recovery mode. These trends create a positive feedback loop. Indeed, the DM economies account for 60% of emerging market (EM) exports, so as their real import growth accelerates, EM exports are rebounding. What’s more, an improving EM outlook reduces DM disinflationary pressures.

How sustainable is this recovery? Typically business cycles end with macrostability risks (price, external and financial) spiking, forcing policymakers to tighten monetary and/or fiscal policy. In this cycle, considering that emerging markets inflation and current account balances are moving toward their central banks’ comfort zones, it is unlikely that macrostability risks will surface soon. Moreover, the emerging markets now have high levels of real rate differentials vis-àvis the US, providing adequate buffers against normalization of the Federal

DEVELOPED MARKET RISK. In our view, the key risk to the global cycle is apt to come from the developed markets— most likely the US, considering that it is most advanced in the business cycle. Moreover, the US tends to have an outsized influence on the global cycle, particularly the emerging markets. While price stability features prominently in debating the monetary policy stance of any central bank, financial stability is clearly emerging as an equally important factor.

How will it play it out? For insight, we can look at history. The late ’60s saw fiscal expansion at a time of strong growth and low unemployment. In the mid ’80s, the US pursued expansionary fiscal and protectionist policies in an improving economy. We look at similarities and differences versus today, analyzing asset class performance by fiscal deficit and unemployment quartiles.

To that end, private-sector leverage has picked up modestly in the US. In fact, the household-sector balance sheet, which was the epicenter of the credit crisis, had been deleveraging until 2016’s third quarter. Moreover, the regulatory environment has been relatively credit-restrictive. Hence, we see moderate risk to financial stability. However, risks could rise, considering that monetary policy is still accommodative, and particularly so if the administration eases financial regulations. Price stability is a critical risk, too—especially since the core Personal Consumption Expenditures Index inflation rate is close to the Fed’s target and US unemployment is around the rate below which inflation could accelerate. Reflecting this, we expect the Fed to hike rates six times by year-end 2018 (see page 3). We expect other major DM central banks to take a less dovish/more hawkish stance

A link to the full report is posted in the Subscriber's Area.
The MSCI World Index broke out to new all-time highs in March and continues to extend that breakout. There is no denying that the Index is heavily weighted by the USA but it has been a generally firm period for global stock markets as economic growth figures pick up against a background where interest rates are still relatively accommodative.

Email of the day on China's deleveraging

Good morning Eoin. I attempted to send this message from my mobile which I fear I bungled. I expect you must have a mountain of email daily, not least the amount which must be caught up after your travels. I hope you had a great trip. You may recall, I asked a month ago for your thoughts on liquidity in China. The Regulators have continued to rein in, essentially squeezing out smaller banks. I found it interesting that the Govt took a survey of banks regarding their recent policies, or is that positive. In any event, I will re-produce the article, I refer below:

Thank you for your warm regards and the attached article from Market News. We had a wonderful trip to Asia. Thanks to Mrs. Treacy’s guangxi, I had the pleasure of having lunch with a senior Citic Securities dealer while in Beijing in 2014 who explained that the only game in town at the time was lending to private investment clubs which he referred to as “Chinese hedge funds”.

Email of the day on Chinese liquidity

Thank you for the above article which raises some interesting points about the Chinese shadow banking system and liquidity in the financial sector generally. Here is a section:

China’s smaller lenders faced tighter liquidity this week as benchmark money market rates climbed to the highest level since April 2015, reflecting a mix of technical factors including cash hoarding for quarter-end regulatory checks. By letting borrowing costs rise, the People’s Bank of China may have been sending a warning to over-leveraged lenders, according to Banco Bilbao Vizcaya Argentaria SA. The central bank has been known to allow short-term jumps in money market rates to discourage excessive borrowing.

“The PBOC wants to warn the smaller lenders not to play the leverage game excessively,” said Xia Le, chief economist at BBVA in Hong Kong. “It’s a tug of war between the central bank and the financial institutions.”

Hong Kong Stocks Jump to 2015 High as Fed, China Energize Bulls

This article by Richard Frost for Bloomberg may be of interest to subscribers. Here is a section:

Hong Kong equities are back at heights unseen since China devalued its currency in August 2015.
A dovish Federal Reserve, China growth optimism and steady mainland inflows combined to fuel a 2.1 percent rally in the Hang Seng Index on Thursday, the biggest advance in almost 10 months. The gain also pushed the gauge firmly above the 24,000 level -- an effective ceiling for the past seven years. China Unicom Hong Kong Ltd. and Link REIT were among the day’s best performers, while Cathay Pacific Airways Ltd. was one of only two decliners after posting a loss on Wednesday.

Hong Kong-listed equities are particularly vulnerable to shifts in sentiment toward U.S. monetary policy thanks to a currency peg with the greenback, while the increasing dominance of Chinese companies on the city’s benchmarks means national economic indicators have a powerful pull. With investors relieved the Fed didn’t increase the projected pace of rate hikes and fears of a Chinese hard landing receding, the serially under-performing Hang Seng Index may have room to rally further.

With a pegged currency the Hong Kong market is heavily influenced by Fed policy but that effect is exacerbated by the Renminbi’s relative weakness versus the Dollar which makes Hong Kong a more attractive destination for mainland flows.

Email of the day on cannabis and steel

For information. Canopy has made an offer to buy Mettrum for Canopy stocks. This will triple my Canopy position and will help you to understand the reason for the similar chart pattern since early December.

On your presentation yesterday (that I watched today), I was intrigued by the iron ore comment. Canadian iron ore companies (have a look at: Alderon, Labrador iron ore...) are on fire and I sold way too early exactly because I saw China slowing down and their financial situation reminded me of USA 2007-2008.

So stock piling for war?.... hmm.. It is true that the US never really got out of the depression woes until their implication in the WW2 conflict, which they used also to help breaking European French and English ''Empires'' among others. This is certainly something to watch, and Trump ''shoot first'' attitude probably add to the concern for sure.

Thank you for this additional intelligence on the Canadian cannabis sector. Iron-ore is an interesting market because steel is such a political sector. China is expected to account for 71% of global steel production this year according to this article from CNBC. That’s a lot of supply and not all of it is designed to cater to the domestic market.

Behind China's Bond Selloff, a Risky Twist on the Repo Trade

This article by Shen for the Wall Street Journal may be of interest to subscribers. Here is a section:

As much as 12 trillion yuan ($1.73 trillion) in bonds—or 19% of the country’s $9 trillion bond market—could be subject to such repurchase agreements, according to an estimate by Shui Ruqing, president of bond clearing-house China Central Depository & Clearing Co., cited last month in China’s influential Caixin Magazine. Traders say the deals are so opaque that even estimates are hard to make.

Banks sometimes use the “dai chi” agreements to move risky assets temporarily off their books during earnings periods or audits, the people said. Brokers like Sealand typically use them to borrow quickly and flexibly—leveraging their investments many times over, they said.
Until last year, Chinese financial regulators had largely ignored the practice, beyond saying they opposed it during a bond-market crackdown in 2013. But the informal nature of dai chi also meant the trades could be difficult to enforce when conditions worsened.

“Because it’s not really an official business, agreements aren’t legally binding,” said the executive who had bought bonds from Sealand.

Sealand’s problems became apparent on Dec. 15, when the southern China-based company announced that two of its traders had forged dai chi agreements worth 16.5 billion yuan ($2.4 billion), a move that market participants interpreted as meaning the broker didn’t intend to honor the deals.

The amount was more than five times what Sealand had declared in its Sept. 30 financials as its financial assets under official repurchase agreements, and more than seven times its disclosed bond-holdings.

China has developed extraordinarily quickly from a closed backwater into a massive financially significant hub. While the pace of development has been blistering the evolution of regulatory standards of governance has been much more moderate. The single party system where cronyism, nepotism and the modern equivalent of simony combine to ensure just about anything is permissible, provided your social standing is within the correct circle, and only exacerbates the situation.

Bitcoin is a small market compared to national currencies, However there is no getting around the fact that Chinese traders represent the majority of participants in that market. Therefore rather that Bitcoin representing the primary organ for money leaving the country it has been the victim of its own limited success by embarrassing monetary policy makers.

Yuan Pares Record Rally as Goldman Says Now's the Time to Sell

This article from Bloomberg News may be of interest to subscribers. Here is a section:

The offshore yuan is sinking because there is some recovery in the dollar, perhaps the unwinding of short-yuan positions has mostly been done, and it’s closing the gap with the onshore currency,” said Roy Teo, senior currency strategist at ABN Amro Bank NV in Singapore. The yuan is likely to weaken this year as capital outflows continue and the U.S.
Federal Reserve increases interest rates, Teo said.

China’s central bank raised its daily reference rate by 0.92 percent to 6.8668 per dollar on Friday, following a 1 percent drop in a gauge of the greenback’s strength overnight.

The offshore yuan was trading 0.8 percent weaker at 6.8457 per dollar as of 5:23 p.m. in Hong Kong, paring its weekly gain to 1.9 percent, the most in data going back to 2010. The onshore rate slumped 0.6 percent. Friday’s fixing was weaker than Mizuho Bank Ltd.’s prediction of 6.8447 and Australia & New Zealand Banking Group Ltd.’s estimate of 6.8456.

The three-month yuan interbank rate in Hong Kong, known as Hibor, surged to a record high, while the overnight rate jumped 23 percentage points to 61 percent, the highest since last January’s cash crunch. Rising interbank rates can make some short positions prohibitively expensive.

The Chinese administration has attempted to squeeze short sellers in much the same way it did a year ago when it believed perceptions of the Yuan as a one way bet were too prevalent. That does not mean the Chinese don’t want, or perhaps more importantly need, a weaker currency. They do but they want it to weaken in a measured manner.

Bitcoin Suffers Biggest Fall in Two Years Following China Currency Gains

This article by Martin Baccardax for Bloomberg may be of interest to subscribers. Here it is in full:

Bitcoin's value suffered its biggest single-day decline in two years Thursday, just hours after China's offshore yuan posted its biggest two day gain and days after the cryptocurrency touched $1,000.

The price of bitcoins against the U.S. dollar fell 13% in London trading, changing hands at around $950 each by 13:45 GMT. Bitcoins traded as low as $880 during a volatile session which saw it reach as high as $1137, according financial bookmakers IG.

The moves follow the biggest two-day gain on record for China's offshore yuan, which trades more freely than the domestically controlled currency of the world's second-largest economy. Speculation of government buying led the gains as investors bet authorities are determined to stem capital outflows and avoid a sustained decline in the currency ahead of the inauguration of President elect Donald Trump, who has vowed to label China as a currency manipulator.

The connection is relevant in the nearly all of the daily trading in bitcoin is linked to the yuan, which has fallen more than 7% against the dollar over the past year, as speculators attempt to skirt currency controls and ensure value.

The offshore yuan gain 1% to 6.7989 against the greenback in Asia trading, putting downward pressure on the dollar index and boosting the yen in foreign exchange trading. The move whipsawed the dollar index, a measure of its strength against a basket of six global currencies, from a near 14-year high on Tuesday to three-week low of 101.74 by the start of European trading before it recovered to 102.10 by 13:45 GMT

I have been pointing out in recent audios that China represents the majority of Bitcoin trading and what goes on in that country is likely to have a profound impact on the value of the cryptocurrency. In many respects we might look on Bitcoin as the anti-Renminbi because it tends to do best when Chinese investors are worried about the stability of their domestic currency.

China Said to Consider Options to Back Yuan, Curb Outflows

This article from Bloomberg News may be of interest to subscribers. Here is a section:

China’s currency stockpile has probably shrunk further after hitting a five-year low of $3.05 trillion in November, according to the median estimate in a Bloomberg survey before data due as early as this week.

Capital outflows from China accelerated in recent months as the yuan suffered its worst year of losses against the U.S. dollar since 1994, declining 6.5 percent. About $760 billion left the country in the first 11 months of 2016, according to a Bloomberg Intelligence gauge. The yuan will decline 2.7 percent the rest of this year, according to the median estimate in a Bloomberg survey.

“The policies, if implemented, can help increase foreign-exchange supply in the onshore market, and hence help defend the yuan in the short term,” said Carol Pang, vice president for fixed income, currency and commodities at Zhongtai International Holdings Ltd. in Hong Kong. “However, it won’t change market expectation of further depreciation.”

The Renminbi is somewhat oversold at present following a quicker pace of depreciation in the last quarter than seen in the three-year downtrend to date. Therefore there is scope for a reversionary rally or at least some steadying.

China Throws Out South China Sea Rule Book

This article by Andrew Browne for the Wall Street Journal may be of interest to subscribers. Here is a section:

During the Cold War, rules of the road, diligently adhered to, prevented accidents that might have brought the U.S. and the Soviet Union to war. China and the U.S. have been working on similar protocols. Last week’s apparently calculated act of lawlessness, though, changes the game.
Between Mr. Trump’s cavalier approach to China’s sacred cows, and China’s new disdain for legal niceties, expect regular eruptions. China is clearly testing U.S. resolve.

A shift in strategy assumes of course that the decision to snatch the drone came from the top rather than a rogue commander, though the latter possibility is just as ominous: It would raise questions about Mr. Xi’s sweeping reorganization of the armed forces designed to impose greater Communist Party control.

Mr. Xi’s administration has declared “maintaining stability” to be its top task for 2017 as the economy sputters. Now, the challenge from Mr. Trump to Beijing is forcing both countries into uncertain waters. Mr. Xi’s navy has just literally and figuratively rocked the boat.

Change doesn’t come easily and for a decade just about everything went right for China. Its economy was growing faster than any other. Hundreds of millions of people were lifted out of poverty and into the middle classes. China’s new consumers are feted all over the world and Hollywood blockbusters pander to Chinese sensibilities. Meanwhile the USA went through a massive credit crisis, was mired in two unproductive wars in the Middle East and Afghanistan, while Europe has spent almost a decade wallowing in the misery of austerity.

This article by Yifan Xie and John Lyons for the Wall Street Journal may be of interest to subscribers. Here is a section:

Some of these bubbles have burst dramatically over the last 18 months, with the crash in China’s stock markets last summer the most notable example. On Thursday, the pain spread to China’s $9 trillion bond market, which remains overwhelmingly driven by domestic investors, despite some opening up to foreigners this year. The yield on 10-year government bonds had reached as low as 2.6% in August.

“People woke up to the fact that the bond bubble is too large,” said Hao Hong, co-head of research at Bocom International, which is owned by Hong Kong’s Bank of Communications. “The bond market in China is under severe pressure, across the board.”

The U.S. Federal Reserve’s decision to raise interest rates helped trigger the selloff. Chinese investors believe it increases the chance China will guide its own rates higher to stem the yuan’s recent decline against the dollar and heavy capital outflows from the country.

But the bond market slump also exacerbates the policy dilemma facing China’s central bank. It has tightened short-term lending in recent weeks in an effort to make it harder for speculative investors to borrow money. The problem is that such tightening moves—along with any future rate rises—could provoke market plunges and panics as liquidity dries up.

One of the greatest challenges the Chinese administration has is that many of its capital markets are dominated by individual investors rather than institutions. Coupled with a wide spread between the lending and deposit rate speculation is rife and that tends to encourage manic periods of both buying and selling.

China Warns Trump Against Using Taiwan for Leverage on Trade

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China warned Donald Trump against using the One-China policy regarding Taiwan as a bargaining chip in trade talks, a swift response that indicates Beijing is losing patience with the U.S. president-elect as he breaks with decades of diplomatic protocol.

“Adherence to the One-China policy is the political bedrock for the development of the China-U.S. relationship,” Foreign Ministry spokesman Geng Shuang told reporters in Beijing at a regular briefing on Monday. “If it is compromised or disrupted, the sound and steady growth of the China-U.S. relationship as well as bilateral cooperation in major fields would be out of the question.”

Trump said in an interview broadcast on Sunday that his support for the policy --- which has underpinned U.S. behavior toward Taiwan since the 1970s -- will hinge on cutting a better deal on trade. He has repeated his accusations against China since election day, telling a crowd in Iowa last week that China would soon have to “play by the rules.”

Policy makers in Beijing initially had a more subdued response after Trump departed from diplomatic convention earlier this month and spoke by phone with Taiwan’s president. Now things are getting more serious: The official Xinhua News Agency warned that world peace hinges on close and friendly ties between the U.S. and China.

“For China, there is no balancing of trade and Taiwan,” said Wang Tao, head of China economic research at UBS AG in Hong Kong. “Taiwan is considered the utmost core interest of China, not for bargaining.”

China has been flexing its military muscle in the South China Sea for the last few years to the alarm of its neighbours but with very little push back from the rest of the world. Additionally it has been steadily increasing what it is spending on arms, with the total soaring from $123 billion in 2010 to an expected $233 in 2020.

Hong Kong's Squeezed Money Market Sends a Sell Signal on Stocks

This article by Justina Lee for Bloomberg may be of interest to subscribers. Here is a section:

"Even with two expected U.S. rate hikes next year, the rate gap with Hong Kong won’t be wide enough to spur significant outflows," said Thomas Shik, acting chief economist at Hang Seng Bank Ltd. Investors also like Hong Kong because of its currency peg with the strong greenback and Asia’s higher growth potential, he added.

There are money market concerns on both sides of the Hong Kong-mainland border. The Shanghai Composite Index retreated the most in six months on Monday as concern about dwindling liquidity was exacerbated by a regulatory crackdown to insurers’ stock investments and Donald Trump’s remarks about the U.S.- China trade relationship.

Currency weakness, along with concern mainland assets are overpriced, has driven Chinese investors to put their cash in Hong Kong equities and homes. China is now stepping up restrictions on outflows to defend the yuan, including tightening curbs on its citizens buying insurance in Hong Kong.

The city has also raised its stamp duty to rein in its world- topping home prices. “Inflows from China may slow because of recent measures," said Steven Leung, Hong Kong-based executive director at UOB Kay Hian. "Hong Kong hasn’t seen outflow pressure, but next year it will be more obvious."

HIBOR rates has been depressed for a long time but are rising in line with LIBOR as the island’s peg with the US Dollar will force an interest rate hike next week. That will represent a change for the property market which has soared as a leveraged bet on easy Fed monetary policy.

China's Central Bank Is Facing a Major New Headache

This article from Bloomberg News may be of interest to subscribers. Here is a section:

People’s Bank of China Governor Zhou Xiaochuan already has one policy headache with the currency falling to near an eight-year low. He could have an even bigger one next month.

That’s when a $50,000 cap on how much foreign currency individuals are allowed to convert each year resets, potentially aggravating capital outflow pressures that are already on the rise. If just 1 percent of China’s almost 1.4 billion people max out those limits, that’s an outflow of about $700 billion -- more than the estimated $620 billion that Bloomberg Intelligence estimates indicate has already flowed out in the first 10 months of this year.

Middle class and wealthy Chinese have been converting money into other currencies to protect themselves from devaluation, exacerbating downward pressure on the yuan. Outflows could intensify if Federal Reserve interest-rate hikes fuel further dollar appreciation.

That leaves Zhou in a bind identified by Nobel-prize winning economist Robert Mundell as the “impossible trinity” -- a principle that dictates nations can’t sustain a fixed exchange rate, independent monetary policy, and open capital borders all at the same time.

"At a moment like this, you have to compare two evils and pick the less-worse one," said George Wu, who worked as a PBOC monetary policy official for 12 years. "Capital free flow may have to be abandoned in order to maintain a relatively stable currency rate."

The $50,000 limit of foreign transfers is per person, so a family with two parents, one child and four grandparents can send $350,000 overseas with no need to resort to more sophisticated methods of transferring funds. There are of course many alternative routes to sending money overseas. So far rules aimed at controlling flows have focused on corporations and purchases of foreign real estate in the order of $1 billion but the flow of retail funds on aggregate represents a very large figure overall.

A China recovery is coming

Thanks to a subscriber for this article by Simon Hunt in copperworldwide.com. here is a section:

China’s economy is recovering. Accommodating monetary policy is being augmented by expanding the fiscal deficit which might include tax cuts. Construction is beginning to recover since total surplus inventory has fallen to the key seven-month level. The NDRC has released 25 infrastructure projects most of which were frozen earlier this year because cases of corruption were detected. Both wages and consumer spending continue to increase. In some key manufacturing sectors inventories have been reduced. Many private sector companies are now managing cash flow appropriately so are improving profitability. Investment will follow in 2017. Against this background real consumption of metals has begun recovering and will gather pace in 2017.

One of the reasons China has been going through such a difficult time is because many of the markets it sends exports to have been in difficulty. The US credit crisis, the EU’s sovereign debt and banking crisis and the collapse of commodity prices all hit demand for China’s exports.

Email of the day on Hong Kong listed Chinese shares

Hong Kong listed Chinese shares, represented by the China Enterprises Index (H-Shares) outperformed the mainland market until about September and has been engaged in a process of mean reversion since. The Hang Seng Index did even better but has also pulled back more recently.

China's Yuan Tumbles to Eight-Year Low as Banks Weaken Forecasts

This article from Bloomberg News may be of interest to subscribers. Here is a section:

“The pressure for the yuan to decline could be stronger next year as Trump’s policies could lead to a dollar rally and amid concerns about China-U.S. trade relations," said Harrison Hu, chief greater China economist at Royal Bank of Scotland Group Plc in Singapore. "The People’s Bank of China can curb high volatility with stronger fixings and intervention, but it won’t do so unless outflows surge, as such measures could add great pressures to the foreign reserves."

A record $44.7 billion left China in September in yuan payments, while the nation’s foreign-exchange stockpile shrank the most since January last month. Chinese officials have taken a series of steps to plug capital control loopholes, such as a potential plan to curb transactions that use the bitcoin digital currency to take funds out of the country. UnionPay Co. late last month limited mainlanders from using its cards to buy insurance in Hong Kong.

HSBC Holdings Plc, UBS Group AG and Australia & New Zealand Banking Group Ltd. lowered their yuan forecasts on Tuesday, predicting that the currency will end this year at 6.9 per dollar, compared with earlier estimates of 6.8 for the first two lenders and 6.75 for the third. BMI Research, a unit of Fitch Group, downgraded its year-end forecast to 6.85 from 6.8, while Norddeutsche Landesbank said it has revised its view to 7 from 6.8.

The Dollar has been trending higher against the Renminbi since early 2014 but the pace of the advance has picked up following the US election. The rate paused at CNY6.4, 6.6, 6.7 but has surged through 6.8 this week. The Renminbi’s depreciation is part of Chinese government policy since it is needs a weaker currency to soften the blow from the rationalisation of heavy industry particularly in the steel, cement and coal sectors. However it will want to avoid an unruly decline and therefore the quicker the Dollar rises the greater the risk of some form of intervention.

This article by Lingling Wei and Jeremy Page for the Wall Street Journal may be of interest to subscribers. Here is a section:

“Lou Jiwei’s abrupt ouster sends a strong signal that any prospects of even limited economic reforms are falling prey to President Xi’s focus on consolidating his power,” said Eswar Prasad, a Cornell University professor and former China head of the International Monetary Fund.

Since coming to power in late 2012, Mr. Xi has been moving away from the party’s decadeslong collective leadership model and centralized decision-making within a number of small committees he heads. Last month, he was named the “core” of the party’s leadership—a designation giving him an even stronger perch to influence the outcome of the congress in late 2017.

At that time, up to five of the seven current members of the Politburo Standing Committee, the top leadership body, are due to retire. In addition, more than 60% of the 376-seat Central Committee—which includes ministers, state industry chiefs and army generals—are expected to be replaced. Still, despite his consolidation of power, party insiders say Mr. Xi still has to vie with departing and retired leaders seeking to promote their own favorites.

With so many powerful positions becoming vacant over the next two years it is little wonder that Xi is attempting to ensure his favourites accede. Not only does it give him the potential to strengthen his own power base but perhaps even more importantly it gives him to the opportunity to encroach on the power structures of his adversaries. As a result we can anticipate a great deal of activity around which group within the Party will succeed in holding what positions.

What drove the October ferrous rally?

Thanks to a subscriber for this report from Goldman Sachs covering the iron-ore market. Here is a section:

$/CNY was one of the most important market drivers of 2H 2015. When China weakened its currency in August 2015, it sent shockwaves around the globe with the S&P 500 index falling 10%. In the third quarter of 2016, $/CNY stayed range-bound between 6.6 and 6.7. In October, however, the depreciation resumed and $/CNY is now approaching 6.8.

The recent CNY depreciation is different from previous rounds of $/CNY moving higher. It has not generated the same international spillover effects as it did back in 2015. This implies further room for the Chinese government to weaken its currency against the US Dollar without negatively affecting global demand for its exports. On the other hand, the link between $/CNY and capital outflows remains strong. Our China Economics team estimated that FX outflows from China rose to US$78 billion in September and are likely to be even higher in October (Exhibit 7). This implies that there is an underlying desire among onshore investors to move into dollar-linked assets. Such desire may become particularly strong whenever the pace of CNY depreciation picks up. In fact, onshore commodities prices increased across the board on October 25 after the $/CNY moved higher for three consecutive days.

There are reasons why iron ore may be the first in line to benefit from onshore investment flows into commodities amidst renewed CNY depreciation. For example, the iron ore futures curve is almost always backwardated, making long iron ore a positive-carry trade. To the extent that a higher $/CNY also leads to a weaker local currency on a trade-weighted basis, iron ore may benefit from potentially higher Chinese steel exports. Additionally, rebar and iron ore are the most traded commodities in the onshore futures exchanges. Exhibit 8 shows the positive correlation between iron ore futures trading volumes and the $/CNY in recent months. By our estimates, about 60% of the iron ore price rally in October can be explained by the CNY depreciation.

If the correlation between the appreciation in iron-ore prices and the deprecation of the Renminbi are indeed causal rather than coincidental that could continue to be positive for commodity prices considering how much a weak currency benefits China’s economy.

China's Factory to the World Mulls the Unthinkable: Price Hikes

This article from Bloomberg may be of interest to subscribers. Here is a section:

China’s factories may be on the cusp of delivering a new shock to the global economy after years of undercutting rivals with cheaper costs. This time, increases in prices could reverberate around the world.

To understand why, consider the dilemma facing Jiangmen Luck Tissue Mfy Ltd., now caught in a squeeze between surging wages and tepid demand. The company has already slashed staff by half, shaved prices and automated production to survive. Now, with margins razor thin, it’s weighing the first price increases since 2010.

"There’s just no possibility for me to cut prices any more," says deputy director Roger Zhao, 52, whose company is based in the city of Jiangmen in southern Guangdong province.

"Because costs are already pretty high and I don’t see any possibility they’ll go down, I’m seeking opportunities to raise prices a little bit."

That push to recover lost margins -- even as demand remains muted -- was shared by exporters of everything from clocks to jacuzzis interviewed in Guangzhou last week at the Canton Fair, a biannual gathering where 25,000 exhibitors and 180,000 mostly foreign buyers ink export deals in booths spanning exhibition space equivalent to about 3,400 tennis courts.

For the world economy, decisions from companies like Jiangmen Tissue to stop cutting prices -- and even raise them where demand allows -- removes a source of disinflationary pressure. To be decided is whether China, the factory to the world, swings from becoming a drag on consumer prices to a source of pressure nudging them higher.

Chinese factories have been dealing with margin compression for years. Labour costs have been on a steady upward trajectory while commodity prices have been a mixed blessing. However right now both are increasing and despite the danger of losing their competitive edge the first signs of price hikes are emerging. This article from a couple of weeks ago highlights the first rise in China’s producer price index in nearly five years.

Rio Gives Away Giant Iron Ore Field Once Worth Fighting For

This article by Thomas Biesheuvel for Bloomberg may be of interest to subscribers. Here is a section:

The writing has been on the wall for a while. The company took a $1.1 billion writedown on Simandou in February. New Rio Chief Executive Officer Jean-Sebastien Jacques said in August “there is no obvious way to take Simandou to the next phase,” and the company hasn’t been able to find a way to finance it.

“It cleans another dead asset off the portfolio,” said Hillcoat, who added that the market doesn’t apply any value to the asset. “In the brave new world we’re in now, you just can’t develop these projects.”

Guinea will want the new owner, also known as Chinalco, to fare better than Rio. The country is counting on the project to double the size of its $6.5 billion economy and turn it into the third-biggest exporter of iron ore. Earlier this year, Guinea blamed project delays on the “ramblings of the technical team in London,” a reference to Rio.

The parties should finalize the deal quickly to establish a new plan for Simandou’s development, Minister of Mines and Geology Abdoulaye Magassouba said in an e-mailed statement.

“This is a very positive event for the project, but we still have many months of work and major challenges ahead,” Magassouba said.

Before the deal was signed on Friday, Simandou was 46.6 percent owned by Rio, 41.3 percent by Chinalco, and 7.5 percent by the government.

Investors have lamented the inability of mining executives to conduct successful M&A activity and I’ve even heard more than a few suggest CEOs should be precluded from engaging in mergers as a condition of taking the job. Simandou is another example of a boondoogle project that was initiated when prices were high and abandoned when prices are bottoming.

Interesting charts October 5th 2016

SPDR Utilities Index – With bond yields beginning to rise, “bond proxies” like the Utilities ETF, which yields 3.47%, has now broken to a new low and is trading below its trend mean. A clear upward dynamic will be required to stem the decline.

China's Ambitious Plan to Make the Yuan the World's Go-To Currency

This article by Robin Ganguly and Cedric Sam for Bloomberg may be of interest to subscribers. Here is a section:

The world will only play along if China leaves the yuan alone

One of the basic definitions of a reserve currency is that it must be freely traded. And the yuan is not quite there yet. The People’s Bank of China is often suspected of intervening in the market to nudge its exchange rate one way or the other. The central bank also limits onshore daily moves to 2 percent on either side of a fixing that it sets. Then there are capital controls, which restrict the ability to move money out of the country.

Despite this, people have found ways to move money out to escape yuan depreciation pressures and a volatile stock market. An estimated $1 trillion has flowed out of China since September 2015.

The Federal Reserve Bank of Dallas suggested in July that the yuan failed a safe-haven test, finding that China’s currency underperforms as market volatility increases.

SDR inclusion is likely to prompt the Chinese government to push ahead with reforms to its
exchange-rate policy, as part of its efforts to bolster international usage of the currency. But challenging the dollar’s hegemony will take more than a while, with the memory of the shock August 2015 devaluation relatively fresh in investor minds. The greenback has maintained its dominance since the mid-20th century, fighting off competition from the yen and the euro.

After the IMF in 2010 rejected China’s request to include the yuan in the SDR basket, the nation took several steps to support its claim. It made the yuan’s fixing more market-based, allowed greater access to its bond market and closed the gap between the currency’s rates at home and abroad. In November last year, the IMF deemed that the yuan was freely tradable enough to become a global reserve currency.

In the long run, a stronger yuan could be a much-needed fix for the global economy as it would increase the purchasing power of China, the biggest consumer of commodities in the world.

I find it interesting that this article assumes the Chinese Yuan is likely to become stronger as reforms are instituted and the currency gains access to the IMF’s Special Drawing Rights. There is another way of thinking about the development.

China's Productivity Growth is the Worst Since the Asia Crisis

This article from Bloomberg News may be of interest to subscribers. Here is a section:

Labor productivity in the world's second-largest economy increased 6.6 percent last year to $7,318 per person, National Bureau of Statistics and International Labour Organization data show. The level, calculated as average inflation-adjusted gross domestic product per employed person per year, measures the efficiency of workers economy-wide.

China kicked off a big surge in efficiency in the early 2000s after entering the World Trade Organization, implementing aggressive reforms to streamline state corporations and allowing more of a private real estate market. But even after those gains it still lags far behind more productive economies in Europe, Japan and the U.S.

With a shrinking working-age population already hurting economic growth, China must boost the value created by each worker if it is to join the ranks of the world's wealthy economies. The hope is that upgraded machinery, services sector advances and a shift up the value chain will help make workers more efficient--and maybe even shorten the badminton lunches.

At over $7000 per person China is squarely in the middle income bracket of global economies. However that figure is distorted by the inequality evident within a population of over 1 billion where extraordinary wealth contrasts with profound poverty in the hinterland. If China is going to march towards continued standard of living improvements then productivity growth will need to continue and that will be contingent on government appetite for economic reform.

Yuan Bears Emerge From Hibernation as Fed Threatens G-20 Calm

This article by Justina Lee for Bloomberg may be of interest to subscribers. Here is a section:

Derivative markets are pointing to renewed bets on yuan depreciation, with a three-month measure of expected price swings poised for the biggest monthly increase since January. Other indicators, such as the premium on options to sell the yuan over those to buy and the discount of forward contracts over the spot rate, have also climbed, indicating rising expectations for declines.

The increased pessimism comes after a period of calm that sent the measures to the lowest in at least nine months as the Federal Reserve held off on raising interest rates and investors bet that China would steady the yuan before it hosts a Group of 20 meeting in September. Traders are probing the People’s Bank of China’s willingness to allow the yuan to fall between the G-20 gathering and the currency’s entry into the International Monetary Fund’s Special Drawing Rights on Oct. 1, especially with the chances of Fed action increasing.

"After G-20 ends next Monday, the market may want to test how much yuan depreciation the PBOC can tolerate," said Gao Qi, a strategist at Scotiabank in Singapore. "China doesn’t want the yuan to move too much during G-20 and become a topic of discussion. SDR’s impact will be smaller than G-20."

China is under the spot light as it prepares to host the G-20 summit next week and not least because it wants to use the event as an opportunity to showcase its newly found position as an economic superpower. However the fact the Chinese administration is engaged in a massive transition from an investment and export oriented business model to one more supported by internal consumption, services and high technology cannot simply be ignored.

Emerging Markets Are Hot, Except for China

This article by Mia Lamar and Rachel Rosenthal for the Wall Street Journal appeared in Saturday’s edition but the authors might have wished they waited another day before publishing. Here is a section:

The wariness partly reflects how unnerved global investors remain by markets that have proved exceptionally unpredictable, even by emerging-market standards. After surging 60% in the beginning of last year, Chinese stocks tipped into a selloff that sent Shanghai’s benchmark index down as much as 41% from June to August. The index rebounded briefly last fall, then plunged 23% in January. The yuan, meanwhile, logged a 5% loss against the dollar in 2015, following an unexpected devaluation one year ago that helped to spur enormous outflows of money as panicked Chinese sent cash abroad.

Many investors say they are disturbed by steps China has taken to tame market convulsions, from heavy-handed currency intervention and the buying of shares by state-backed funds, to allowing widespread trading suspensions of shares and blaming “malicious” forces for stock-price falls.

Others say they remain concerned about China’s economic slowdown, and suspect conditions may be worse than official figures suggest.

Chinese officials have stressed measures by Beijing to address the concerns of global investors, and played down concerns about growth. “The Chinese economy is a ‘stability anchor’ for the global economy,” Premier Li Keqiang said last month. “Prophecy of China’s economy heading for a hard landing is rarely heard now.

Many of the limitations imposed on the Chinese market have been aimed at inhibiting speculation following a particularly tumultuous period in 2015. That is a condition which is in sharp contrast to the environment on a number of other international indices.

Chinese regulators messed up the launch of options trading, and timing its debut with the opening of the Shanghai – Hong Kong connection only exacerbated the short term mania. In trying to avoid a crash they threw every measure available to stem the decline and there is plenty of evidence over the last six months that the 3000 level on the CSI300 is being defended.

Today's interesting charts

Indonesia – The Jakarta Composite is now testing the March 2015 peak and while overbought in the short-term a clear downward dynamic will be required to signal more than temporary resistance in this area..

Amazon Takes on Alibaba With Japan Portal for Chinese Shoppers

This article by Grace Huang and Reed Stevenson for Bloomberg may be of interest to subscribers. Here is a section:

“The opportunity is huge,” said Jasper Cheung, president of Amazon Japan. “We have already increased the selection that we can export by the millions over the last several weeks.”

Chinese shoppers are looking for authentic Made-in-Japan products, spooked by tainted baby milk and fake merchandise proffered on web stores in China. While that’s helping to drive an influx of shoppers to Japan -- 3.08 million Chinese tourists have visited the archipelago so far this year, up 41 percent -- it’s also boosting demand for Amazon.co.jp, Wandou and other web outlets featuring Japanese goods.

Rakuten Inc., the Japanese online store, also lets people shop for stuff from Japan in Chinese, as well as in Korean and English. Amazon’s Japan website has been available in English for years.

The new iteration of Amazon Japan’s shopping portal, in simplified Chinese, offers millions of products with more coming, the company said. Consumers in Asia’s biggest economy are demanding access to authentic brands and quality, from clothing and cosmetics to baby products and health goods. That’s why Costco Wholesale Corp. has a shop on Alibaba’s Tmall.com, while Macy’s Inc. and other U.S. retailers are tapping into China’s dominant online-payments system by accepting Alipay on their sites.

For billions of new consumers entering the middle classes their first taste of consumerism is likely to be via their mobile phones where they are aggressively marketed to via Wechat, Facebook, Instagram and a host of other social media sites. That puts dominant online marketplaces like Amazon, Alibaba, Ebay and Rakuten in a favourable position to compete for their business and China represents a major battleground. Uber’s experience in China highlights the difficulty of doing business in that country where one is competing with a domestic copycat operation. Amazon’s strategy of building out its Japanese operation may act as a hedge to domestic Chinese operations where it competes directly with JD.com and Alibaba.

Macau's Chief Sees 2017 Economy Returning to Growth on Casinos

This article by Daniela Wei for Bloomberg may be of interest to subscribers. Here is a section:

“Macau’s gaming industry and the whole economy will continue to adjust, but the decline may shrink to 7.2 percent this year and even resume growth in 2017,” Chief Executive Fernando Chui said in a televised session of the city’s legislature Wednesday. “It’s a good time for Macau to re-position after a 25-month gaming revenue drop.”

Gross domestic product in Macau declined 20.3 percent in 2015, worsening from the 0.9 percent drop the year before, as the world’s largest gambling hub was hurt by China’s anti-corruption campaign that scared off high-rollers. The casino industry, which accounts for half of Macau’s GDP, is in the midst of a casino building boom to boost revenue from mainstream gamblers and tourists.

Recreational Gamblers
Macau’s government is working with its six casino operators to “improve synergies” between gaming and non-gaming pursuits, Chui said. The city is trying to reduce its reliance on gambling and is targeting to raise the proportion of casinos’ non-gaming revenue to 9 percent by 2020 from 6.6 percent in 2014.

The outlook for the gaming sector and China are inextricably linked. Macau represents a much larger gambling market than even Las Vegas and that city also depends on the largesse of Chinese high rollers to drive profitability. With the outlook for growth improving in Macau that may be an initial sign that the Chinese tourist market is still healthy.

Hong Kong Bears Pile Record Short Bets on China Consumer Stocks

This article by Kana Nishizawa for Bloomberg may be of interest to subscribers. Here is a section:

Chinese consumer stocks are in the cross- hairs of Hong Kong’s short-sellers.

Bearish bets on Tingyi (Cayman Islands) Holding Corp. and Want Want China Holdings Ltd. soared to record highs since May, data compiled by IHS Markit Ltd. show. The instant noodles and snacks manufacturers, together with sanitary-napkin maker Hengan International Ltd., make up three of the four most-shorted stocks on Hong Kong’s benchmark index. Hengan this month spun off its food business into a separately listed unit that’s down 27 percent from its first close through Thursday.

Bears are betting that China’s shift toward an economy driven by middle-class spending will leave some consumer stalwarts behind. Even after valuations on Tingyi and Want Want fell to all-time lows at the start of the year, the stocks are still too expensive as Internet retailing helps foreign brands grab market share in China, according to Ample Capital Ltd.

Shoppers are showing a preference for healthier food, UOB Kay Hian Holdings Ltd. says. “Consumers have been changing their pattern to more nutritional products so their business growth is declining,” said Johnson Hu, a Shanghai-based analyst at UOB Kay Hian. “We don’t see that changing in the foreseeable future.”

Short interest in Want Want and Tingyi has risen to 7.6 percent and 4.9 percent of their outstanding shares as of Tuesday, Markit data show. Bearish bets in Tingyi surged to a record level this month, and those in Want Want are close to all-time highs last seen in May. The average of similar wagers for the 50 Hang Seng Index members was about 1.3 percent.

The evolution of online retail has had a dramatic effect on the ability of bricks and mortar stores in North America and now that pattern is likely to be repeated elsewhere as the convenience of online shopping trumps the toil of driving and walking to a store only to have to carry home the goods afterwards. The additional fact that diabetes is a major problem in both China and India suggests the potential for concerted drives to eat healthier more nutritious foods is more likely than not.

Samsung in Talks With BYD to Buy Stake in Electric-Car Maker

This article from Bloomberg may be of interest to subscribers. Here is a section:

BYD said Samsung has been actively pushing forward talks about buying its shares in a private placement. Talks are still underway, the Chinese company said, denying a report by the Korea Economic Daily that an agreement was reached to acquire a 4 percent stake.

Samsung is pursuing the investment after its affiliate was among foreign battery makers left off a list of suppliers approved by China, where sales of electric vehicles are surging and the government has sped up construction of charging points.

The talks with BYD also add to the global trend of technology companies and automakers collaborating as car buyers increasingly demand more advanced powertrains and features that improve connectivity and safety.

China is the world’s largest car market. With a concerted government backed push into electric vehicles any company seeking to ride the wave to emerging automotive technology cannot afford to lose access to the market. Therefore BYD represents an attractive avenue for foreign investors. While in the USA Tesla sets the pace for what other companies are expected to provide, China’s state mandated vision for zero emissions represents an even more important influence on the market. Car companies have to try and build products for a global audience in order to keep costs under control. Therefore any company seeking to compete globally needs to have a foothold in China.

The Brexit hoopla has diverted our attention from the real problem

This article by Elena Holodny may be of interest to subscribers. Here is a section:

"There is an argument that global investors have overly focused on Brexit at the expense of other more important macro events, "the perma-bear wrote in a recent note to clients.

"We believe China's ongoing stealth devaluation of the renminbi is far more important for the global economy."

The renminbi has been pretty stable against the US dollar this year, so many have missed that it.
Yet China's trade-weighted currency basket has dropped by about 10% since right before the August, which you can see in the chart shared by Edwards below.

(For what it's worth, Julian Jessop of Capital Economics pointed out the same interesting detail back in May, arguing that the "stealth devaluation" was an "important nuance that many have missed.")
As for what the significance of this is, here's Edwards again:

"The Wall Street Journal has reported that this is a deliberate shift in policy link. China is now exporting its deflation, and my goodness it has a lot of deflation to export. In the Ice Age world, countries need to devalue to avoid deflation. So if sterling slumps in the aftermath of a Brexit vote there may be at least one silver lining outside the EU if the UK economy manages to avoid the quagmire of outright deflation."

This is a tumultuous week and many markets have been subject to a great deal of volatility but next week will bring us back to the debate of central bank liquidity and how well it offsets concerns about corporate profitability.

MSCI Rebuffs Chinese Equities for Third Time in Blow to Xi

This article from Bloomberg News may be of interest to subscribers. Here is a section:

“The MSCI decision signals that China remains a closed emerging economy that uses market techniques like freezing the market and making it illegal to short, using government funds to buy shares -- techniques that are not welcome among global investors,” Paul Christopher, head global market strategist at Wells Fargo Investment Institute, said by phone. “There are a number of market reforms in progress, but these are the decisions MSCI would want to wait for and examine.”

MSCI’s ruling won’t affect the nation’s capital market reforms, Deng Ge, a spokesman for the China Securities Regulatory Commission, said in a statement on the regulator’s website. Indexes that don’t contain A shares are incomplete, according to the statement.

The fact Chinese indices both on the mainland and in Hong Kong had been declining ahead of the decision suggests investors were not pricing in the possibility that MSCI would decide in China’s favour. However what does appear to have happened today is that support was provided to the Chinese market in order to forestall any additional selling pressure in response to the announcement.

MSCI Optimism Revives China Stocks With Biggest Gain Since March

This article from Bloomberg News may be of interest to subscribers. Here is a section:

Chinese stocks were shaken out of their May torpor after Goldman Sachs Group Inc. said it was likely the nation’s shares would be included in MSCI Inc.’s global benchmark indexes.

The Shanghai Composite Index jumped 3.3 percent at the close for its biggest increase in almost three months. The gains were accompanied by a pick up in turnover, which had fallen to levels last regularly seen in 2014, while brokerages surged. The rally was uninterrupted by a sudden plunge in stock-index futures, which fell by the 10 percent daily limit before snapping back in less than a minute.

The odds of Chinese stocks winning MSCI inclusion have increased to 70 percent from 50 percent just last month, thanks to new rules aimed at curbing trading halts and a clarification by the regulator about beneficial ownership rules, Goldman Sachs said Tuesday. The Shanghai gauge still dropped 0.7 percent in May, extending the world’s worst performance this year, amid concern the economic slowdown will hurt earnings and as the yuan heads for its biggest monthly loss since August’s devaluation.~

“The market is expecting that mainland shares will have a pretty high chance of joining the MSCI’s global indexes next month,” said Wang Zheng, Shanghai-based chief investment officer at Jingxi Investment Management Co.

The prospect of MSCI membership was one of the contributing factors in the spike experienced by mainland Chinese shares last year. When the decision was to wait and see rather than approve membership the market was robbed of a potent source of demand and the leverage that had built up with the introduction of options trading was put under pressure.

The Little-Known Alibaba Unit That Prompted an SEC Probe

This article from Bloomberg news may be of interest to subscribers. Here is a section:

One issue for the SEC appears to be how Alibaba accounts for Cainiao’s financial performance. Alibaba includes results from Cainiao using the equity method, which counts profits and losses as a proportion of an investment. Considering Alibaba’s high ownership and control over the logistics business, regulators may be asking whether Alibaba should completely consolidate Cainiao into its results, said Paul Gillis, an accounting professor at Peking University’s Guanghua School of Management.

In 2015, Cainiao posted a net loss of 617 million yuan ($94 million) on sales of almost 3.1 billion yuan, Alibaba said. That year, Alibaba recorded its percentage of the loss on its books, $46 million. At the same time, the e-commerce company reported a $128 million gain on investments in Cainiao and other entities.

The gain, which helped offset the operating losses, was probably due to the higher valuation that Cainiao fetched in its latest funding round, according to Sanford C. Bernstein & Co. In March, Cainiao announced its first round of external fundraising, with financing from investors including Temasek Holdings Pte, GIC Pte and Khazanah Nasional Bhd. That gave the delivery network a valuation of about $7.7 billion, Caixin reported, citing people familiar with the matter

The issue is not so much with the size or performance of Alibaba’s logistics subsidiary but rather in the opacity with which the company deals with its shareholders. Alibaba is not alone in this regard. Google’s reorganisation and issuance of C shares and Facebook’s reorganisation to ensure Zuckerberg’s control both exemplify a trend toward less shareholder oversight of management decisions. Against that background Alibaba’s governance issues are non-trivial but arguably they are already in the price.

China and the world: New Frontiers, Fresh Connections

Thanks to a subscriber for this report from HSBC highlighting the increasingly important role played by the Chinese economy in spurring global growth. Here is a section:

The story now is that China has been increasingly moving up the value chain. In 1995, labour-intensive products such as toys and shoes (grey line in chart 13) accounted for 36% of China's overall exports. By 2015, this share was down to 26%. Meanwhile, the share of machinery and transport equipment (blue line) increased from 21% to 46% over the same period. Soon this transition was starting to have a global impact. Chart 13 shows China's world share by product. Although China's world market share had increased quite steadily for most categories of products, it is the improvement in machinery and transport equipment that is the most striking. In two decades, China's global market share rose from a mere 4% to 17%. Incidentally, this is how China has increasingly earned more in terms of trade surplus vis-à-vis the rest of the world (Chart 14).

In more recent years, a decrease in China’s commodity exports has become another noticeable trend. Chart 15 shows China's declining dominance in the exports of primary commodities and metal products and an improving market share in manufactured goods such as lighting, telecoms, etc.

So, where might China's trade go from here? On most metrics, China's export industry still has much room for improvement. China has recognised that it needs innovation to move up the value chain. It needs to differentiate its products through advances in technology, design or other attributes. The recent five-year plans have included elements related to innovation, R&D and even intellectual property rights. The transition from a low-cost producer to one that increasingly makes more value-add is a longer-term trend that has just begun and it is by no means an easy one. Greater openness to foreign investment, as well as domestic reforms, will help make this process a smoother one.

And for other emerging markets, China moving up the value chain creates opportunities. Countries in parts of Africa and Asia with lower costs of production will likely benefit from a production shift away from China and towards even lower cost bases. China's rise up the ladder may pull a few countries with it.

China has come a long way and for much of its hinterland the performance of its economy exerts a leash effect in much the same way Wall Street does for the USA’s largest trading partners. It is for that reason we tend to pay such close attention to what is happening In China’s stock and currency markets as well as the political machinations of what is still a highly orchestrated market.

Buy Robot. Silicon Valley Misses a Trick as China Nabs Kuka

This article by Chris Bryant and Nisha Gopalan for Bloomberg may be of interest to subscribers. Here is a section:

Adding robotics exposure makes sense, as rising Chinese labor costs are expected to drive a big increase in factory automation there. At present, China uses much less automated manufacturing than more developed economies such as South Korea and Germany.
China's robot sales rose 16 percent last year, according to the International Federation of Robotics, which predicts that by 2018 it will account for more than one third of industrial robots installed worldwide.

So you can see the strategic sense of a Kuka deal. But it still begs the question: why didn't Silicon Valley jump in here? Midea's offer values Kuka's equity at 4.5 billion euros ($5 billion), chump change for the likes of Google, Apple or Amazon.

And yes, that whacking great premium is surely designed to see off any potential white knights, but -- just like China -- the U.S. tech giants aren't restricted by the usual rules of corporate finance.

There's been a lot of big talk there about robotics, but besides Amazon's clever acquisition of Kiva, which makes robots that whizz around its logistics centers, we've seen little fruitful action. In March, Google beat a partial retreat by putting its Boston Dynamics unit up for sale.

Of course, the U.S. reigns supreme in software, increasingly central to the success of robotics. But if you want to own the future, you'll have to marry that expertise to intelligent hardware. And it's here where Kuka excels.

The German company has branched out beyond its car-plant robot roots to other sectors, including electronics and medical applications. It's taking a run at the so-called "internet of things" by making its machines easier to program. Its lightweight model called the iiwa is a technological wonder that can work side-by-side with humans, without a safety cage.

China is investing heavily in automation because having achieved the moniker “workshop of the world” it intends to hold onto it as labour costs rise. However there is another reason China Inc. is on such a buying spree; acquiring everything from luxury hotels and food companies to robotics in the last year.

Email of the day on China and governance

In Friday’s audio, you speculated about possible reasons for China’s tightening of social conditions. The following report from an Australian reporter in China, leaves me with little doubt. Xi has already shown his cards. If the country is opaque today, the future will be more so. If governance is everything, China will be a laggard.

My first assessment was that more centralization and tougher social conditions in China would delay economic growth but I now think the opposite is just as likely.

The need for economic reform has been obvious but progress has been slow. Debt has increased, excess capacity remains a serious problem while attempts to influence stock markets were ham-fisted. The failure of the bureaucracy is evident but implementing tough economic policies in the face of public resistance has been difficult. The existence of the country’s strongest unions in the infrastructure and heavy industry sectors, seems to have made change impossible.

In the West we are seeing how democratically elected governments are being taken over by populists whose promises are unrealistic and mostly damaging to their economies. In Australia we are at day nine in an eight week election campaign where the economically conservative government, which is acutely aware of the nation’s unsustainable path, is struggling to sell a moderate budget which sees debt continuing to increase while depending also on continuing world economic growth and financial stability.

Premier Xi has no intention of allowing China to go down that same path. He can see the country’s problems as clearly as we can but the system has failed.

I can easily see Xi blaming bureaucrats and weak leadership in the provinces. The scene is being set for a major purge. A second cultural revolution. Xi can see what the markets are saying and he could use his power to implement tough economic policies. There will be significant short term social pain and major economic risks but a strong turnaround in the economy is likely to emerge. China could regain its position as an economic powerhouse.

The period of turmoil will see China’s markets collapse. This will be a black swan event. Knock-on effects around the world will be serious but, as is often the case, will be another good long term buying opportunity.

Thank you for sharing your perspective and this article highlighting the increasingly leftist leanings of Communist Party rhetoric. Most forward looking societies prize bettering oneself through pursuing education and China is no different. Therefore regardless of how you dress it up in idealism, relegating the most educated people in society to its lowliest echelons can only be considered a retrograde step.

Asked the general trend of the first quarter start

This missive attributed to an “authoritative source” from the central government of China highlights the challenges facing the administration as overcapacity in a number of key sectors is unwound. Here is a section from the Google Translation:

However, it is undeniable that we are faced with the inherent contradiction has not fundamentally resolved, some new problems have also been exposed. "Stability" of the foundation is still mainly rely on the "old way", that is investment-led, large fiscal balance pressure in some areas, increased economic risk probability. Especially private enterprises to invest in a substantial decline in the real estate bubble, an increase in excess capacity, non-performing loans, local debt, equities, foreign exchange, bonds, and so the risk of illegal fund-raising point. Some lower market-oriented, industrial low-end, single structure of the region, economic downward pressure is still increasing, highlighting the problem of employment, social conflict has intensified. Thus, in the face of the main contradiction is down structural than cyclical situation, "into" is "stable" foundation. "In" is to solve the economic operation of the supply side, structural and institutional issues, which will take time, is still in the initial stage, the new power is also not afford to pick beam.

Comprehensive judgment, our economy can not be U-shaped, but can not be V-shaped, but the L-shaped trend.

Want to emphasize that this is an L-shaped stage, not a year or two past. The next few years, the overall weak demand and overcapacity coexist hard for fundamental change, economic growth is not possible, as once picked up it will continue upward as before and one after another to achieve high growth years. "Step back" in order to "two steps forward." We are confident about the development prospects of China, China's full economic potential, toughness, large room for maneuver, if not exciting, not much speed down. In this regard, it must be internalized in the heart outside of the line. Some economic indicators to rebound, do not visibly; some economic indicators down, do not panic.

Generally speaking when we hear from an unnamed authoritative source in what is considered a mouthpiece for the central government it is taken as a tacit reflection of standing committee perspective. An L-shaped recovery aimed at the rationalisation of overcapacity and acceptance that the bad loans problem will need to be dealt with, can be viewed as net positives. This is despite the fact it means China is unlikely to be the global growth leader in the next five years that it was in the last decade.

CLSA Sees China Bad-Loan Epidemic With $1 Trillion of Losses

This article by Paul Punckhurst for Bloomberg may be of interest to subscribers. Here is a section:

Cheung’s assessment adds to warnings from hedge-fund manager Kyle Bass, Autonomous Research analyst Charlene Chu and the International Monetary Fund on China’s likely levels of troubled credit. The IMF said last month that the nation may have $1.3 trillion of risky loans, with potential losses equivalent to 7 percent of gross domestic product.

CLSA cites a diminishing economic return on stimulus pumped into the economy as among the reasons for a worsening outlook, with Cheung saying at a briefing that bad loans had the potential to rise to 20 percent to 25 percent.

“China’s banking system has reached a point where it needs a comprehensive solution for the bad-debt problem, but there is no plan yet,” he said in the report.

Concerns about the scale of nonperforming loans have been voiced by international investors on more than a few occasions over the years and yet very little has been done to tackle the issue. In fact the ham-fisted approach to market regulation under the Xi administration has probably exacerbated the problem.

China Rolls Up Welcome Mat

This article by Andrew Browne for the Wall Street Journal may be of interest to subscribers. Here is a section:

No, China isn’t closing for business. Compared with many other developing countries, it remains wide open. It is the world’s largest manufacturer, biggest trader and a magnet for foreign investment. About three-quarters of China’s high-tech exports come from foreign-invested companies.

China’s antiforeign turn is driven by several related trends. First, President Xi Jinping has a much lower tolerance than Deng for the unwelcome intrusion of foreign ideas about democracy, press freedom and individual rights that come along with trade and investment—what Deng called “flies and mosquitoes.”

The other day, Mr. Xi was railing against “Western capitalist values” invading the Communist Party’s own training schools.

Second, Mr. Xi is pushing ideology harder than any leader in decades. Increasingly, China sees itself in ideological confrontation with the West. In addition to stressing Marxism, Mr. Xi’s administration is seeking to revive traditional Chinese culture to counter Western ideas—thus, the hostility to crosses.

And Mr. Xi is promoting a strident form of nationalism. One aspect of this is much greater Chinese assertiveness in territorial disputes with neighbors, including Japan, Vietnam and the Philippines. Another is an explicit set of government policies aimed at helping Chinese firms replace their foreign rivals in the domestic market.

All of this adds uncertainty to the outlook for foreigners who have landed on China’s shores. The 2010 census put their number at almost 600,000, not including residents from Hong Kong, Macau and Taiwan.

“Governance is Everything” has been a mantra at this Service for decades. China made massive steps in opening up to foreign investment and became the world’s factory floor in a very short period of time; creating massive wealth along the way. Co-operation with the wider world always came on China’s terms such as requiring domestic partners and technology sharing but there was the quid pro quo in terms of access to the growing Chinese consumer base.

Cloudy with a chance of monetization

Thanks to a subscriber for this report from Deutsche Bank which many of interest. Here is a section

US colleagues Karl Keirstead and Ross Sandler describe public cloud services as "the biggest and most disruptive trend impacting the technology industry." DB estimates the total addressable market for cloud to be USD500b. Cloud service providers have captured only a low-single-digit piece of this TAM. In China, the opportunity is even younger and less penetrated. AliCloud is the clear hometown favorite, with 65% of DB survey respondents using its solutions. Alibaba is our preferred play on cloud over Tencent and Baidu, which have much smaller cloud businesses that should also grow appreciably.

China: catching the “growth story” even earlier on; both public and private
The value proposition of the public cloud is simple: enabling deep cost savings and freeing up resources for enterprises to pursue more core business activities. While public cloud revenues at AliCloud and others continue to grow in the triple digits, China is also seeing strong growth in private cloud, as government bureaus, SOE’s and large private companies heed government exhortations to reform their hidebound IT regimes behind its “Internet+” initiative. Before the introduction of the cloud, about 70-80% of companies’ IT budgets and time were spent on low-value-added areas such as infrastructure maintenance, upgrades and integration. With external cloud operators taking over these burdens, management is able to concentrate on growth-centered initiatives, with cloud assisting in saving time and expense. Some 72% of respondents to our survey indicate that they are reducing significantly their IT spend through the use of cloud computing services. Alibaba Research Institute, for instance, estimates that 70% of computing costs can be saved.

China's CIO speaks: results of DB proprietary survey
As part of our overview of China's nascent cloud industry, we surveyed more than 50 CIO's, CTO’s, Directors and VPs of IT. Results revealed cloud computing to be the #1 priority this year, followed by security services at #2, and IT infrastructure and datacenters at #3. These companies expect to spend approximately 27% and 30% on cloud computing services in 2016 and 2017, respectively, compared to 20% in 2015. Over 50% of the respondents stated that they were able to save up to 40% of their IT spending thanks to cloud computing.

Making the state owned sector more nimble is a primary policy objective of the Chinese administration. Under Xi Jinping, the desire to have an all-encompassing database, with greater visibility over the affairs of various agencies has reached new heights and the expansion of cloud services gels with that ambition. That’s is likely to fuel growth in both the private and public sectors.

Panama Papers probes opened, China limits access to news on leaks

This article from Reuters may be of interest to subscribers. Here is a section:

Leading figures and financial institutions responded to the massive leak of more than 11.5 million documents with denials of any wrongdoing as prosecutors and regulators began a review of the reports from the investigation by the U.S.-based International Consortium of Investigative Journalists (ICIJ) and other media organizations.

Following the reports, China has moved to limit local access to coverage of the matter with state media denouncing Western reporting on the leak as biased against non-Western leaders.

The issue of offshore accounts is an emotive one not least for those lacking the financial resources to benefit from the protections they offer. This represents a challenge both for the jurisdictions that provide these services but also for their clients in an environment where supposedly private correspondence can be publicly aired. It’s all the more puzzling because many of the legal services that can be provided by these firms are often achievable by staying onshore but structuring one’s affairs in line with the valid interpretations of domestic law.

China's Shadow Banking Evolves to Dodge Crackdown

This article by Justina Lee for Bloomberg may be of interest to subscribers. Here is a section:

“If you talk to a bank, they’ll say it’s somebody else’s credit risk,” Smith said. “But the ultimate credit risk doesn’t disappear. The brokers for sure are not taking this on in exchange for a few basis points, so ultimately the banks are still holding onto this credit risk. If it all goes bad, the brokers don’t have the balance sheet to support it, and somebody else has to come in and take it over."

Shadow banking hit the headlines in 2014 when a 3 billion yuan product issued by China Credit Trust Co. to raise funds for a coal miner faced default. The product was bailed out four days before the payment was due, though it wasn’t clear who provided the funds. Growth in AMPs has slowed every year since 2012, when rules on brokerages’ asset management businesses were first eased and such plans surged 575 percent.

The mechanics of the Chinese shadow banking sector seems to bear a lot of similarities with the types of special purpose vehicles set up by companies like AIG in the USA during the housing boom.

As with the challenge that faced the USA, the issue did not come to a head until the central bank had tightened monetary policy to a point where the supply of credit to such vehicles was choked off. Right now the new regulator’s resolve in supporting markets appears to be under scrutiny.

Wider China-Hong Kong Discrepancy Revives Fake Trade Doubts

This article from Bloomberg news may be of interest to subscribers. Here is a section:

The discrepancy suggests China’s trade recovery in December was inflated by fake invoicing to skirt capital controls and profit from the difference between the yuan’s exchange rates in on-shore and off-shore currency markets.

In a twist to fake invoicing in 2013, when the government said export and import figures were overstated due to the phony trade to bring money into the mainland, the refreshed practice has more to do with capital outflows from China. Outflows jumped in December, with the estimated 2015 total reaching $1 trillion, Bloomberg Intelligence estimates show.
Offshore Affiliates

"The divergence of trade data indicates a potential use of the trade channel for financial arbitrages," said Raymond Yeung, a Hong Kong-based senior economist at Australia & New Zealand Banking Group Ltd. Given how the spread between the onshore and offshore yuan widened in December, exporters and importers "may move funds across the border through trading with offshore affiliates. By blowing up trade figures, traders may potentially receive a larger forex quota to move their funds abroad."

Quarantine Alert as China Infects Singapore's Banks

This article by Andy Mukherjee for Bloomberg may be of interest to subscribers. Here is a section:

Two, pessimism is setting in just when the city's benchmark interbank borrowing rate is climbing. To the extent Singapore banks' net interest margins in recent years have been hostage to the abundance of cheap money, investors had a reason to be optimistic. Clearly, China-related jitters are trumping any hopes of them being able to turn their low-cost deposits into higher-priced loans, especially without a revival in the property market:

Three, the pecking order has changed since China's shock Aug. 11 devaluation. Before that, UOB, the smallest of the trio by market value, had the lowest price-to-book ratio. Now it has the highest. Interestingly, this shift has occurred even as analysts have marked down their estimates of UOB's 2015 per- share earnings by almost 3 percent over the past four weeks. It seems investors are giving UOB the benefit of the doubt because of its lower exposure to Asia's biggest economy:

Ultimately, though, it's impossible to accurately assess Singapore banks' actual vulnerability to a China meltdown. All three are regional lenders with significant corporate loan books at a time when companies in Asia are facing deep distress because of the way China's flagging demand for commodities has caught them off guard. Ripples in the high-yield bond market are giving a strong signal that 2016 may well turn out to be a year of accelerated loan-loss provisions for them. Investors may be right to seek cover.

Singapore has benefitted enormously from its status as a private banking centre over the last decade. The rise of China, India and wider ASEAN has created plenty of demand for the strong governance and professionalism to be found in the city state. That’s worth remembering as the banking sector is buffeted by currency market volatility, China’s slowdown, the commodity bear market and rising interest rates.

Hong Kong Dollar Forwards Sink to Weakest Since 1999 on Peg Bets

This article by Saijel Kishan and Dominic Lau for Bloomberg may be of interest to subscribers. Here is a section:

The city’s government bonds tumbled, pushing the 10-year yield to the highest level in 15 months and Hong Kong’s Hang Seng Index of shares dropped the most since Aug. 24 and as rising local borrowing costs threaten to further brake an economy reeling from a collapse in Chinese shares and the slowest growth in the mainland in 25 years. The yuan’s slide to a five-year low in the first week of January triggered weakness in emerging Asian currencies this month, led by a 3.4 percent drop in South Korea’s won.

“It’s like an attack all fronts on Hong Kong,” said Nordine Naam, global macro strategist at Natixis in Paris. “Investors are getting more and more risk adverse, especially with regards to China and so they’re getting out of the region. For the time being, Hong Kong has lost its safe haven status.”
Hong Kong Monetary Authority Chief Executive Norman Chan said Monday he expects the local currency to decline to the lower limit and reiterated his commitment to keeping the linked exchange-rate system. It had traded at the strong end of the range as recently as Jan. 4. He said Wednesday that the International Monetary Fund is also a supporter of the mechanism.

Hong Kong brought in the peg in 1983 after a 30 percent plunge in the local dollar’s value led to panic buying of rice and other staples. Former HKMA chief Joseph Yam in 2012 called for a review of the peg, having in 1998 conducted $15 billion of stock purchases to fend off speculative attacks on Hong Kong’s equity and currency markets.

“The Hong Kong dollar is a victim of all the risk aversion across global markets given what’s happening with China,” said Tommy Ong, managing director for treasury and markets at DBS Hong Kong Ltd. “Dollar pegs across the globe are under pressure but I trust that the Hong Kong peg will stay in place because there are no better alternatives given the volatility we’ve seen with the yuan.”

Following a visit to Hong Kong in October I came away with the impression that housing was drastically overvalued and the impending change in the US interest rate cycle would be bad news for the sector. There is a running argument on the ability of the US economy to tolerate the strength of the Dollar but a consensus is evident in the belief a number of countries and regions maintaining Dollar pegs can ill afford currency strength at the present time.

Top Forecaster Sees Aussie Demons Capping Gains as Bottom Near

This article by Candice Zachariahs for Bloomberg may be of interest to subscribers. Here is a section:

Bialas estimates that a “big chunk” of Aussie underperformance came from the unraveling of carry trades that involved, in particular, borrowing euros at near zero percent to buy a currency linked to a higher benchmark rate. The Reserve Bank of Australia cash rate currently stands at 2 percent and policy makers have signaled a reluctance to take it any lower.

Australia last month capped its strongest year for job growth since 2006, with the country’s services sector propelling gains as the mining industry cooled.

“I expect the Aussie-U.S. dollar to bottom sometime in the second quarter,” Bialas said, “as improved competitiveness of sectors unrelated to mining, a strong labor market and a recovery in inflation will give rise to speculation about the return of the RBA to raise interest rates later this year.”

Few developed markets are as exposed to China as Australia so the relative weakness of the Australian Dollar has been a reflection of stress in its largest export market. With Chinese government yields testing the lows seen in 2008 the potential for measures to support economic growth to be announced is growing and that may act to stem the Aussie’s decline.

China's Mixed Signals Have Eichengreen Questioning 'Competence'

This article by Anna Andrianova for Bloomberg may be of interest to subscribers. Here is a section:

It’s clear that they have responded very poorly and very erratically so far, especially in the past year,” said Eichengreen, author of “Hall of Mirrors,” a book analyzing the crises of the Great Depression and the Great Recession. “They can’t quite decide if they want the exchange rate be more flexible or not, they can’t communicate clearly to the markets.”

The measures to shore up the Chinese currency and plug an outflow of capital risk setting back the long-held goal for an internationalized yuan. The People’s Bank of China said Monday that lenders in offshore yuan-trading centers will now have to lock away a share of deposits in its accounts, ending the exemption for foreign institutions in a push to curb speculation against the currency. That followed large-scale intervention in Hong Kong last week that sent yuan borrowing rates in the city soaring to a record as liquidity was temporarily crunched.

In the West we are accustomed to viewing markets through the lens of economics, fundamentals, technicals, and at this service the behaviour of investors. However with China we also need to have a view on the political machinations of the market and the uncertainty widely different personalities can have on the complexion of that market.

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